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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark one)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2003
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from __________ to ________
Commission File No. 000-50343
INTEGRATED ALARM SERVICES GROUP, INC.
(Exact name of Registrant as specified in its charter)
Delaware
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
42-1578199
One Capital Center
99 Pine Street,3rd Floor
Albany, New York 12207
(Address of principal executive offices) (zip code)
(518) 426-1515
(Registrant's telephone number, including area code)
(Former name or former address, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such
shorter period that the Registrant was required to file such
reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
--- ---
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act). Yes___ No X
---
As of November 12, 2003 there were 24,573,640 shares of the registrant's common
stock outstanding.
1
Integrated Alarm Services Group, Inc. and Subsidiaries
Form 10-Q Index
For the Three and Nine Months Ended September 30, 2003
Description
Part I. Financial Information............................................3
Item 1 Financial Statements....................................3
Balance Sheets as of December 31, 2002
and September 30, 2003..................................3
Statements of Operations for the Three and
Nine Months Ended September 30, 2002 and 2003...........4
Statements of Cash Flows for the Nine Months
Ended September 30, 2002 and 2003.......................5
Notes to Financial Statements...........................6
Item 2 Management's Discussions and Analysis of
Financial Condition and Results of Operations..........15
Item 3 Quantitative and Qualitative Disclosures
about Market Risks.....................................23
Item 4 Controls and Procedures................................23
Part II Other Information...............................................24
Item 1 Legal Proceedings......................................24
Item 2 Changes in Securities and Use of Proceeds..............24
Item 6 Exhibits and Reports on Form 8-K.......................25
2
Integrated Alarm Services Group, Inc. And Subsidiaries
(Successor to KC Acquisition Corporation and Subsidiaries)
Balance Sheets
Combined as of December 31, 2002 and Consolidated
as of (Unaudited) September 30, 2003
December 31, September 30,
2002 2003
------------- -------------
(Unaudited)
Assets
Current assets
Cash and cash equivalents $ 442,082 $ 36,159,725
Short-term investments 3,000,000 66,906,572
Current portion of notes receivable -- 602,137
Accounts receivable, net 1,499,762 2,614,032
Prepaid expenses 72,648 1,179,803
Due from related party 346,608 171,167
------------- -------------
Total current assets 5,361,100 107,633,436
Property and equipment, net 2,708,161 2,454,052
Notes receivable net of current portion -- 2,126,124
Dealer relationships, net 27,560,912 24,225,441
Customer contracts, net -- 34,084,836
Goodwill, net 7,218,743 59,425,759
Debt issuance costs, net 1,047,221 1,940,657
Restricted cash and cash equivalents 1,163,229 1,129,914
Other assets 568,431 575,391
------------- -------------
Total assets $ 45,627,797 $ 233,595,610
============= =============
Liabilities and Stockholders' (Deficit) Equity
Current liabilities:
Current portion of long-term debt, related $ 1,738,724 $ --
Current portion of long-term debt 3,059,879 9,681,000
Current portion of capital lease obligations 146,316 153,541
Accounts payable and accrued expenses 4,680,313 3,812,522
Current portion of deferred revenue 3,812,626 5,642,876
Other liabilities -- 407,211
------------- -------------
Total current liabilities 13,437,858 19,697,150
Long-term debt, net of current portion, related 10,696,537 --
Long-term debt, net of current portion 29,566,223 57,634,841
Capital lease obligations, net of current portion 361,542 243,937
Deferred revenue, net of current portion -- 344,149
Deferred income taxes 2,458,738 723,200
Other liabilities 384,480 384,571
Due to related party 285,300 169,155
------------- -------------
Total liabilities 57,190,678 79,197,002
------------- -------------
Commitments and Contingencies
Stockholders' (deficit) equity:
Preferred stock, $0.001 par value; authorized 3,000,000 shares -- --
Common stock, $0.001 par value; authorized 100,000,000
shares; issued and outstanding 709,719 shares at
December 31, 2002 and 24,573,640 at September 30, 2003 709 24,574
Common stock subscribed -- 315,342
Paid-in capital 5,554,289 204,559,813
Accumulated deficit (17,117,879) (50,501,121)
------------- -------------
Total stockholders' (deficit) equity (11,562,881) 154,398,608
------------- -------------
Total liabilities and stockholders' (deficit) equity $ 45,627,797 $ 233,595,610
============= =============
The accompanying notes are an integral part of the financial statements.
3
Integrated Alarm Services Group, Inc. And Subsidiaries
(Successor to KC Acquisition Corporation and Subsidiaries)
STATEMENTS OF OPERATIONS
Combined For the Three and Nine Months Ended September 30, 2002 and
Consolidated For the Three and Nine Months Ended September 30, 2003
(Unaudited)
Three months ended Nine months ended
September September September September
2002 2003 2002 2003
------------ ------------ ------------ ------------
Revenue:
Monitoring fees $ 4,468,953 $ 5,930,091 $ 14,334,341 $ 17,872,642
Customer accounts -- 3,679,942 -- 9,747,077
Billing fees 169,796 45,264 471,862 87,761
Related party monitoring fees 500,704 -- 1,060,378 282,250
Related party placement fees 649,595 -- 911,688 90,437
Service and subcontractor fees -- 77,046 -- 168,501
------------ ------------ ------------ ------------
Total revenue 5,789,048 9,732,343 16,778,269 28,248,668
Cost of revenue (excluding depreciation and amortization) 3,445,250 4,247,531 11,174,017 12,001,091
------------ ------------ ------------ ------------
2,343,798 5,484,812 5,604,252 16,247,577
------------ ------------ ------------ ------------
Operating expenses:
Selling and marketing 165,300 229,037 503,277 684,531
Depreciation and amortization 1,283,965 2,189,001 3,952,163 8,609,426
General and administrative 830,614 2,673,240 1,526,001 10,795,519
------------ ------------ ------------ ------------
Total operating expenses 2,279,879 5,091,278 5,981,441 20,089,476
------------ ------------ ------------ ------------
Income (loss) from operations 63,919 393,534 (377,189) (3,841,899)
Other income (loss) 113,195 468,245 1,035,470 205,495
Amortization of debt issuance costs 330,696 1,985,380 760,856 2,892,793
Related party interest expense 329,859 462,381 891,276 914,229
Interest expense 753,039 3,424,199 2,704,576 10,820,616
Interest income -- 608,664 -- 1,113,585
------------ ------------ ------------ ------------
Loss before provision for income taxes (1,236,480) (4,401,517) (3,698,427) (17,150,457)
Benefit (provision) for income taxes 583,481 35,828 550,706 (3,331,345)
------------ ------------ ------------ ------------
Net loss $ (652,999) $ (4,365,689) $ (3,147,721) $(20,481,802)
============ ============ ============ ============
Net loss per share $ (1.18) $ (0.25) $ (5.68) $ (3.02)
============ ============ ============ ============
Weighted average number of common
shares outstanding 553,808 17,269,123 553,808 6,774,349
============ ============ ============ ============
Pro forma income tax to give effect to the
conversion from S to C Corporation status:
Loss before provision for income taxes $ (1,236,480) $ (4,401,517) $ (3,698,427) $(17,150,457)
Benefit (provision ) for income taxes 840,684 35,828 1,820,484 285,143
------------ ------------ ------------ ------------
Net loss $ (395,796) $ (4,365,689) $ (1,877,943) $(16,865,314)
============ ============ ============ ============
Net loss per share $ (0.71) $ (0.25) $ (3.39) $ (2.49)
============ ============ ============ ============
The accompanying notes are an integral part of the financial statements.
4
Integrated Alarm Services Group, Inc. And Subsidiaries
(Successor to KC Acquisition Corporation and Subsidiaries)
STATEMENTS OF CASH FLOWS
Combined For the Nine Months Ended September 30, 2002 and
Consolidated For the Nine Months Ended September 30, 2003
(Unaudited)
For the Nine Months Ended
September 30,
-------------------------------
2002 2003
------------- -------------
Cash flows from operating activities:
Net loss $ (3,147,721) $ (20,481,802)
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:
Depreciation and amortization 3,952,163 8,609,426
Amortization of debt issuance costs 760,856 2,892,793
Interest expense - non-cash, notes 70,652 176,283
Litigation settlement (922,275) --
Provision for (reversal of) bad debts (120,736) 1,023,569
Deferred income taxes (550,706) 3,303,105
Non-cash service fees -- 1,825,000
Changes in assets and liabilities, net of effects of
acquisitions and non-cash transactions:
Accounts receivable 672,386 (1,439,648)
Prepaid expenses 2,245 (1,107,155)
Other assets (483) (6,960)
Due from/to related parties 871,776 (8,331)
Accounts payable and accrued expenses 744,038 (3,306,068)
Deferred revenue (418,822) 1,137,444
Other liabilities -- (14,555)
------------- -------------
Net cash provided by (used in) operating activities 1,913,373 (7,396,899)
------------- -------------
Cash flows from investing activities:
Purchase of property and equipment (847,966) (376,206)
Purchase of customer contracts -- (2,466,319)
Financing of customer loans -- (698,873)
Short-term investments -- (63,906,572)
Repayment of customer loans -- 670,864
Decrease in restricted cash and cash equivalents 379,629 2,880,065
Business acquisitions, net of cash acquired (4,812,010) 8,082,332
------------- -------------
Net cash used in investing activities (5,280,347) (55,814,709)
------------- -------------
Cash flows from financing activities:
Proceeds of initial public offering -- 195,856,512
Proceeds of long-term debt, related party 5,800,000 2,000,000
Proceeds of long-term debt 4,395,000 6,839,404
Payments of obligations under capital leases (32,549) (110,380)
Repayment of long-term debt (4,962,003) (102,100,626)
Repayment of long-term debt, related party (814,078) (3,409,765)
Debt issuance costs (670,000) (145,894)
------------- -------------
Net cash provided by financing activities 3,716,370 98,929,251
------------- -------------
Net increase in cash and cash equivalents for the period 349,396 35,717,643
Cash and cash equivalents at beginning of year 1,224,035 442,082
------------- -------------
Cash and cash equivalents at end of period $ 1,573,431 $ 36,159,725
============= =============
The accompanying notes are an integral part of the financial statements.
5
INTEGRATED ALARM SERVICES GROUP, INC. AND SUBSIDIARIES
(Successor to KC Acquisition Corporation and Subsidiaries)
NOTES TO FINANCIAL STATEMENTS
1. Management Opinion
The financial information as of September 30, 2003 and for the three months and
nine months ended September 30, 2003 and 2002, in the opinion of management,
includes all adjustments, consisting only of normal recurring adjustments, that
are considered necessary for fair presentation of the financial position,
results of operations and cash flows of Integrated Alarm Services Group, Inc.
and Subsidiaries' (IASG or the "Company") for the three months and nine months
ended September 30, 2003 and 2002 in accordance with accounting principles
generally accepted in the United States of America. The results for any interim
period are not necessarily indicative of results for the full year. Certain
information and footnote disclosures normally included in financial statements
prepared in accordance with accounting principles generally accepted in the
United States of America have been omitted. These financial statements should be
read in conjunction with financial statements and notes thereto for the year
ended December 31, 2002 included in the Company's Amended Registration Statement
on Form S-1/A. Certain prior period data have been reclassified to conform to
the current period presentation.
2. Short-Term Investments
The Company has determined that the securities (which are debt securities)
included in short-term investments are classified as held-to-maturity as defined
by the Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting
for Certain Investments in Debt and Equity Securities". The carrying value of
held-to-maturity securities is amortized cost. As of September 30, 2003, each of
the securities held is issued by a U.S. government corporation or agency and
matures in less than 90 days. The aggregate fair value, gross unrealized loss
and amortized cost basis as of September 30, 2003 is approximately $66,898,000,
$9,000 and $66,907,000, respectively.
3. Acquisition of Integrated Alarms Services, Inc.
Integrated Alarm Services, Inc. (IASI) which was acquired on January 31, 2003
provides financing and capital to independent security alarm dealers throughout
the United States. IASI provides working capital to the independent dealers
necessary for the growth of the dealers' business and financing for
acquisitions. IASI has built a vertically integrated infrastructure, capable of
handling all aspects of financing for independent alarm dealers including due
diligence, billing and collections and the securitizing of alarm contracts. IASI
owns a significant portfolio of residential and commercial alarm contracts and
contracts assumed upon the foreclosure of loans to dealers for which it provides
monitoring services (through IASG and other non-affiliated entities) to its
customers.
In connection with the acquisition of IASI and affiliates, IASG issued 864,192
shares of its common stock, of which 525,452 shares were issued to minority
interests for a total fair value of approximately $11,559,944 related to these
acquisitions. The predecessor cost basis in net assets acquired was
approximately ($21,465,000), for which 338,740 shares of common stock were
issued. The transaction was accounted for under the purchase method of
accounting.
6
INTEGRATED ALARM SERVICES GROUP, INC. AND SUBSIDIARIES
(Successor to KC Acquisition Corporation and Subsidiaries)
NOTES TO FINANCIAL STATEMENTS--(Continued)
The allocation of the purchase price of $11,559,944 is as follows:
(in Thousands) January 31, 2003
------------------
Assets:
Current Assets (including cash of $8,082) $ 10,735
Intangibles other than goodwill 33,105
Goodwill 51,892
Other 21,396
---------
Total assets $ 117,128
=========
Liabilities and Stockholders' Deficit:
Current liabilities $ 16,415
Long-term debt, net of current protion 109,705
Other 913
---------
Total liabilities 127,033
Total stockholders' deficit (purchase price of $11,560, net
of predecessor cost basis of $(21,465)) (9,905)
---------
Total liabilities and stockholders' deficit $ 117,128
=========
The allocation of the purchase price was finalized during the third quarter of
2003. As a result of finalizing the pruchase price allocation, goodwill was
increased and customer contracts was decreased by approximately $8,876,000. In
addition, a reduction to amortization expense of approximately $1,308,000 was
recorded in the third quarter of 2003 as a result of the finalization of the
purchase price allocation. The goodwill resulting from the acquisition is
non-deductible for income tax purposes.
The following unaudited proforma combined results of operations have been
prepared as if the acquisition had occurred at the beginning of the year of
acquisition and the beginning of the immediately preceding year.
Nine Months Ended
September 30,
-------------------------------
2002 2003
------------ ------------
Revenue:
Monitoring fees $ 14,334,343 $ 17,872,642
Customer accounts 12,755,383 11,009,118
Billing fees 471,862 221,262
Related party monitoring fees 141,124 141,264
------------ ------------
Total revenue $ 27,702,712 $ 29,244,286
============ ============
Income (loss) from operations $ 404,061 $ (4,149,594)
============ ============
Loss before income taxes $(12,165,299) $(18,442,049)
============ ============
Net loss $(11,598,400) $(21,773,394)
============ ============
The unaudited proforma results of operations do not purport to represent what
the Company's results of operations would actually have been had the acquisition
been effected for the periods presented, or to predict the Company's results of
operations for any future period
7
INTEGRATED ALARM SERVICES GROUP, INC. AND SUBSIDIARIES
(Successor to KC Acquisition Corporation and Subsidiaries)
NOTES TO FINANCIAL STATEMENTS--(Continued)
4. Goodwill and Intangibles
Goodwill was being amortized on a straight-line basis over its estimated useful
life of 15 years through December 31, 2001. Effective January 1, 2002, the
Company adopted SFAS No. 142, "Goodwill and Other Intangible Assets". SFAS No.
142 changed the accounting for goodwill from an amortization method to an
impairment-only approach. For purposes of applying SFAS No. 142, the Company had
determined that it had two reporting units consistent with its two operating
segments. Fair value of the reporting units and the related implied fair value
of goodwill was established using valuation techniques based upon multiples of
earnings and discounted cash flows. An initial transition impairment test of
goodwill was required as of January 1, 2002. The Company completed this initial
transition impairment test during the second quarter of 2002, which did not
result in any impairment charges. An annual impairment test is performed in the
third quarter of each year and, to date, no impairment charges have been
required.
During the three months ended September 30, 2003, goodwill increased by
approximately $9,191,000 of which approximately $8,876,000 was a result of
finalizing the purchase price allocation related to the acquisition of IASI and
the balance, or approximately $315,000, was due to the recognition of contingent
consideration related to the purchase of Criticom.
Customer Contracts and Dealer Relationships
SFAS No. 144 "Accounting for the Impairment of Disposal of Long Lived Assets"
requires that long-lived assets be reviewed for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset may not
be recoverable. Recoverability of the assets to be held and used is measured by
a comparison of the carrying amount of the assets with the future net cash flows
expected to be generated. Cash flows of dealer relationshps and retail customer
contracts are analyzed at the same group level (acquisition by acquisition and
portfolio grouping, respectively) that they are identified for amortization, the
lowest level for which independent cash flows are identifiable. All other
long-lived assets are evaluated for impairment at the Company level, using one
asset grouping. If such assets are considered to be impaired, the impairment to
be recognized is measured by the amount by which the carrying amount of the
assets exceeds the fair value of the assets. Customer contracts were recorded at
fair value on January 31, 2003, the purchase date. The Company has idenitifed no
impairment losses.
Customer contracts at September 30, 2003 consist of the following:
Contracts
Existing Dealer assumed from
Portfolio Acquired dealer Total
------------ ------------ ------------ ------------
Customer contracts (all acquired in 2003) $ 9,003,611 $ 21,754,480 $ 7,970,384 $ 38,728,475
Accumulated amortization (2003 amortization) (878,802) (2,539,617) (1,225,220) (4,643,639)
------------ ------------ ------------ ------------
$ 8,124,809 $ 19,214,863 $ 6,745,164 $ 34,084,836
============ ============ ============ ============
Certain customer contracts acquired as part of the IASI acquisition, with a cost
basis of approximately $12,422,000, were subject to optional repurchase by the
seller at a discounted price. Such repurchase was contingent on the seller
complying with certain conditions outlined in the contract purchase agreement
over a six-year period. The seller has defaulted on the terms of the agreement
and the repurchase option is deemed null and void.
8
INTEGRATED ALARM SERVICES GROUP, INC. AND SUBSIDIARIES
(Successor to KC Acquisition Corporation and Subsidiaries)
NOTES TO FINANCIAL STATEMENTS--(Continued)
Customer contract amortization expense for the nine months ended September 30,
2003 was approximately $4,644,000. Amortization expense was reduced for the
quarter by $1,308,000 as a result of an adjustment to the amortizable basis upon
finalization of the purchase price allocation of the IASI acquisition.
Dealer relationships consist of the following:
December 31, September 30,
2002 Amortization 2003
------------ ------------ ------------
Dealer relationships $ 39,958,089 $ -- $ 39,958,089
Accumulated amortization (12,397,177) (3,335,471) (15,732,648)
------------ ------------ ------------
$ 27,560,912 $ (3,335,471) $ 24,225,441
============ ============ ============
Estimated amortization expense of customer contracts and dealer relationships
for the years ending December 31, 2003 through 2007 is as follows:
Customer Dealer
Year Contracts Relationships Total
- ------------------------------------------------------------------------
2003 $ 6,540,285 $ 4,447,294 $ 10,987,579
2004 7,061,587 3,777,286 10,838,873
2005 6,161,273 2,955,556 9,116,829
2006 5,100,353 2,581,858 7,682,211
2007 3,968,718 2,303,889 6,272,607
5. Long-Term Debt
In June 2003, the Company secured a $20 million account acquisition facility
with LaSalle Bank N.A., which was contingent upon the completion of an initial
public offering with minimum net proceeds of $115 million. The facility is
available to IASG for acquisitions of security alarm companies and pools of
security alarm contracts. The facility has not been closed in spite of the
completion of the initial public offering due to the Company's revised plan to
secure a larger syndicated facility, with LaSalle Bank N.A. as lead lender, at
more favorable terms.
As of September 30, 2003, the Company has paid-off approximately $ 91.9 million
in debt with the proceeds from the initial public offering. As a result of the
debt pay-offs during the third quarter of 2003, unamortized debt issuance costs
of approximately $1,556,000 were charged to expense during the quarter ended
September 30, 2003.
6. Stockholders' Equity
On July 29, 2003, the Company successfully completed its initial public
offering. A total of 22,000,000 shares of common stock were issued at a per
share price of $9.25. The net proceeds to the Company after underwriting
commissions (7%) and other direct initial offering costs were approximately
$187,403,000. The common stock trades on the NASDAQ National Market under the
symbol "IASG".
Concurrent with the offering, Messrs. McGinn, Few, Sr., Smith, Quady and the
former shareholders of Criticom, were issued, in the aggregate, options to
purchase 1,900,000 shares of the Company's common stock (the "Shareholder
Options"). The options will vest as follows: (i) 30% will vest and be
immediately exercisable on the first anniversary of the offering; (ii) 30% will
vest and be immediately exercisable on the second anniversary of the offering;
(iii) 40% will vest and become immediately exercisable on the third anniversary
of the offering. The exercise price of the options are equal to the per share
offering price ($9.25). The shareholder options arrangement which contains a
cashless exercise provision also permits the Company, at its discretion, to
net-share settle the arrangement by the delivery of unregistered shares. The
fair value ($8,550,000) of these shareholder options, as determined under the
Black-Scholes option valuation model, have been charged to accumulated deficit
with a corresponding credit to paid-in capital.
9
INTEGRATED ALARM SERVICES GROUP, INC. AND SUBSIDIARIES
(Successor to KC Acquisition Corporation and Subsidiaries)
NOTES TO FINANCIAL STATEMENTS--(Continued)
On August 27, 2003, the underwriters of the Company's initial public offering
exercised their over allotment option and an additional 982,729 common shares
were issued at a per share price of $9.25. The proceeds to the Company after
underwriting commissions (7%) were approximately $8,454,000.
Stock-Based Compensation
The Company accounts for activity under the employee stock plans using the
intrinsic value method prescibed by Accounting Principals Board Opinion ("APB")
No. 25, Accounting for Stock Issued to Employees, and has adopted the
disclosure-only provisions of SFAS No. 123, Accounting for Stock-Based
Compensation. Under APB No. 25, the Company generally recognizes no compensation
expense with respect to options granted to employees and directors as the option
exercise price is generally equal to or greater than the fair value of the
Company's common stock on the date of the grant.
The following table illustrates the effect on net loss and net loss per share if
the Company had elected to recognize stock-based compensation expense based on
the fair value of the options granted at the date of grant as prescribed by SFAS
No. 123. For the purposes of this pro forma disclosure, the estimated fair value
of the options fully recorded upon issuance as the options are immediately fully
vested.
Three months ended Nine months ended
September 30, September 30,
---------------------------- ---------------------------
2002 2003 2002 2003
------------ ------------ ------------ ------------
Net loss, as reported $ (652,999) $ (4,365,689) $ (3,147,721) $(20,481,802)
Add: Stock-based compensation
included in reported net loss,
net of related tax effects -- -- -- --
Less: Stock-based compensation
expense determined under
fair value method for all awards,
net of related tax effects -- (129,600) -- (129,600)
------------ ------------ ------------ ------------
Pro forma net loss $ (652,999) $ (4,495,289) $ (3,147,721) $(20,611,402)
============ ============ ============ ============
Net loss per share, as
reported-basic and diluted $ (1.18) $ (0.25) $ (5.68) $ (3.02)
============ ============ ============ ============
Pro forma net loss per
share-basic and diluted $ (1.18) $ (0.26) $ (5.68) $ (3.04)
============ ============ ============ ============
SFAS No. 123 requires the use of option valuation models that were not developed
for use in valuing employee stock options. The Black-Scholes option valuation
model was developed for use in estimating the fair value of traded options that
have no vesting restrictions and are fully transferable. In addition, option
valuation models require the input of highly subjective assumptions, including
the expected stock price volatility. Because options held by Company directors
have characteristics significantly different from those of traded options, and
because changes in the subjective input assumptions can materially affect the
fair value estimate, in the opinion of management, the existing models do not
necessarily provide a reliable single measure of the fair value of these
options.
Company stock options outstanding as of September 30, 2003 include options
granted during the third quarter of 2003 to purchase 48,000 shares of common
stock at a weighted average exercise price of $9.25 per share, with a weighted
average contractual life remaining of 9.83 years. As of September 30, 2003 all
of the options outstanding were exerciseable.
10
INTEGRATED ALARM SERVICES GROUP, INC. AND SUBSIDIARIES
(Successor to KC Acquisition Corporation and Subsidiaries)
NOTES TO FINANCIAL STATEMENTS--(Continued)
SFAS No. 123 Assumptions and Fair Value
The fair value of each option grant was estimated at the date of grant using the
Black-Scholes option valuation model with the following weighted average
assumption:
Risk-free interest rate............4.02%
Volatility.........................29%
Option Term (in years).............10
Dividend yield.....................0%
The weighted average estimated fair value of stock options granted during the
quarter ended September 30, 2003 was $4.50 per share.
The following table summarized the activity related to stockholders' (deficit)
equity for the nine months ended September 30, 2003:
Common Stock Common Total
------------------------- Stock Paid-in Accumulated Stockholders'
Shares Amount Subscribed Capital Deficit (Deficit) Equity
------------- ------------- ------------- ------------- ------------- -------------
Balance, December 31, 2002 709,719 $ 709 $ -- $ 5,554,289 $ (17,117,879) $ (11,562,881)
Net loss -- -- -- -- (20,481,802) (20,481,802)
Issuance of commons shares for
acquisition of IASI and affiliates 864,192 865 -- 11,559,079 -- 11,559,944
Predecessor basis in IASI -- -- -- (17,113,351) (4,351,440) (21,464,791)
Issuance of common shares
for consolidation of Morlyn 17,000 17 -- (17) -- --
Issuance of common shares
for initial public
offering of Company's
common stock 22,000,000 22,000 -- 187,380,587 -- 187,402,587
Issuance of common shares
for exercise of
underwriters' over
allotment option 982,729 983 -- 8,452,943 -- 8,453,926
Contingent shares for
Criticom purchase -- -- 315,342 -- 315,342
Imputed Interest
expense associated with
conversion feature of debt -- -- -- 176,283 -- 176,283
Shareholder options -- -- -- 8,550,000 (8,550,000) --
------------- ------------- ------------- ------------- ------------- -------------
Balance, September 30, 2003 24,573,640 $ 24,574 $ 315,342 $ 204,559,813 $ (50,501,121) $ 154,398,608
============= ============= ============= ============= ============= =============
7. Income Taxes
As a result of the merger of KC Acquisition with IASG during January 2003, KC
Acquisition, KC Funding Corp., Morlyn Financial Group and Criticom will no
longer be considered flow through entities to their shareholders and members
and, therefore, must record current and deferred income taxes from its earnings
and losses, and recognize the tax consequences of "temporary differences"
between financial statement and the tax basis of existing assets and
liabilities. At the time of the change in tax status (S to C Corporation) of the
enterprise, the Company recorded an additional deferred tax liability of
approximately $3,505,000, which is being included in income tax expense in 2003.
8. Loss per Common Share The loss per common share is as follows:
Three months Nine months
ended September 30, ended September 30,
--------------------------- ---------------------------
2002 2003 2002 2003
------------ ------------ ------------ ------------
Numerator
Net loss $ (652,999) $ (4,365,689) $ (3,147,721) $(20,481,802)
Denominator
Weighted average shares outstanding 553,808 17,269,123 553,808 6,774,349
Net loss per share $ (1.18) $ (0.25) $ (5.68) $ (3.02)
11
INTEGRATED ALARM SERVICES GROUP, INC. AND SUBSIDIARIES
(Successor to KC Acquisition Corporation and Subsidiaries)
NOTES TO FINANCIAL STATEMENTS--(Continued)
There are outstanding promissory notes which are convertible into 792,793 shares
of common stock at a price of $6.94 per share. Further, there are options
outstanding to acquire 1,948,000 shares of the Company's common stock at a per
share price of $9.25. The shares have not been included as common stock
equivalents, as they would be anti-dilutive.
9. Litigation
In March 2003, Protection One Alarm Monitoring, Inc., ("Protection One") a
company engaged in the business of providing security and other alarm monitoring
services to residential and commercial customers, brought an action against the
Company in the Superior Court of New Jersey, Camden County for unspecified
damages in connection with the Company's purchase of certain alarm monitoring
contracts from B&D Advertising Corporation ("B&D"). B&D had previously sold
alarm monitoring contracts to Protection One. As part of such sales, B&D agreed
not to solicit any customers whose contracts had been purchased and to keep
certain information confidential. Protection One claims that the Company's
subsequent purchase of contracts from B&D constitutes tortious interference,
that the Company utilized confidential information belonging to Protection One
and that Protection One had an interest in some of the contracts that the
Company purchased from B&D. The Company plans to vigorously defend this claim.
The Company believes the resolution of this matter will not have a material
adverse effect on its financial condition, results of operations or cash flows.
In May 2003, a former employee of McGinn, Smith & Co., Inc., brought an action
against the Company, as well as McGinn, Smith & Co., Inc. and M&S Partners for
wrongful termination. The suit brought in the Supreme Court of the State of New
York seeks damages of $10,000,000. In August 2003, we filed a motion to dismiss
the claim against us, which was opposed by the plaintiff on August 27, 2003. The
Court's decision on the motion is still pending. McGinn, Smith & Co., Inc. and
M&S Partners have fully indemnified the Company from any damages or legal
expenses that the Company may incur as a result of the suit. This employee of
McGinn, Smith & Co., Inc. was never the Company's employee and the Company plans
to vigorously defend this claim. The Company believes the resolution of this
matter will not have a material adverse effect on its financial condition,
results of operations or cash flows.
The Company is involved in litigation and various legal matters that have arisen
in the ordinary course of business. The Company does not believe that the
outcome of these matters will have a material adverse effect on the Company's
financial position, results of operations or cash flows.
10. Related Party Transactions
The Company incurred approximately $329,859 and $462,381, respectively, in
related party interest for the three months ended September 30, 2002 and
September 30, 2003 of which approximately $132,577 in 2002 was to IASI.
The Company earned monitoring fees from trusts that are related parties of
approximately $0 and $501,000 for the three months ended September 30, 2003 and
2002, respectively.
The Company will rent office space month to month from a related party through
November 14, 2003. At such time, the Company will commence a lease for office
space from an unrelated party.
Included in long-term debt (junior debt) are contract certificates held by
related parties that totaled approximately $222,000 at September 30, 2003.
11. Swap Arrangement
At September 30, 2003, IASI has an interest rate SWAP arrangement (maturing
March 15, 2004) to fix the interest rate at 8.3% on approximately $1,848,000 of
floating rate senior debt. The interest rate SWAP does not qualify as a hedge
and, accordingly, changes in fair value are recorded as interest expense in the
statement of operations. The fair value of the SWAP at September 30, 2003 was a
liability of approximately $7,960.
12
INTEGRATED ALARM SERVICES GROUP, INC. AND SUBSIDIARIES
(Successor to KC Acquisition Corporation and Subsidiaries)
NOTES TO FINANCIAL STATEMENTS--(Continued)
12. Segment and Related Information
In connection with the acquisition of IASI, IASG acquired IASI's retail services
business. As a result, IASG believes it has two reportable segments: (1)
Alarm-Monitoring wholesale services and (2) Alarm-Monitoring retail services.
The reportable segments are considered by management to be strategic business
units that offer different services and each of whose respective long-term
financial performance is affected by similar economic conditions. IASG has
determined its reportable segments based on its method of internal reporting
which is used by management for making operational decisions and assessing
performance.
The alarm-monitoring wholesale services segment provides monitoring services to
a broad range of independent alarm-monitoring dealers. The alarm-monitoring
retail services segment provides working capital to independent alarm-monitoring
dealers. This is accomplished by purchasing alarm monitoring contracts from the
dealer or by providing loans using the dealer's alarm monitoring contracts as
collateral. IASI provides monitoring services (through IASG and other
non-affiliated entities) to its customers.
Management has determined that an appropriate measure of the performance of its
operating segments would be made through an evaluation of each segment's income
(loss) before income taxes. Accordingly, the Company's summarized financial
information regarding the Company's reportable segments is presented through
income (loss) before income taxes for the three months and nine months ended
September 30, 2003. Prior to January 31, 2003, the Company operated in only one
segment, alarm-monitoring wholesale services. The acquisition of IASI and
affiliates established the new segment, alarm-monitoring retail services for
independent alarm-monitoring dealers. Intersegment revenues have been
eliminated.
Summarized financial information for the three months and nine months ended
ended September 30, 2003, concerning the Company's reportable segments is shown
in the following table:
Alarm-Monitoring Alarm-Monitoring Consolidated
Wholesale Services Retail Services Total
--------------------- ----------------- ---------------
Three Months ended September 30, 2003
Total revenue $ 6,052,401 $ 3,679,942 $ 9,732,343
Cost of revenue (including depreciation and amortization) 5,463,339 973,193 6,436,532
Income (loss) from operations 68,565 324,969 393,534
Interest income 99,443 874,588 974,031
Interest expense 1,011,138 3,240,809 4,251,947
Loss before income taxes (932,984) (3,468,533) (4,401,517)
Nine Months ended September 30, 2003
Total revenue $ 18,501,591 $ 9,747,077 $ 28,248,668
Cost of revenue (including depreciation and amortization) 15,809,873 4,800,644 20,610,517
Income (loss) from operations 1,065,052 (4,906,951) (3,841,899)
Interest income 99,443 1,379,509 1,478,952
Interest expense 3,618,624 8,481,588 12,100,212
Loss before income taxes (3,060,763) (14,089,694) (17,150,457)
As of September 30, 2003
Goodwill $ 7,534,085 $ 51,891,674 $ 59,425,759
There was no material change in the total assets of the reportable segments
during the three months ended September 30, 2003 with the exception of the net
initial public offering proceeds of which approximately $99,700,000 remains in
cash, cash equivalents and short-term investments held by the Retail Services
segment.
13
INTEGRATED ALARM SERVICES GROUP, INC. AND SUBSIDIARIES
(Successor to KC Acquisition Corporation and Subsidiaries)
NOTES TO FINANCIAL STATEMENTS--(Continued)
13. Commitments
In April 2003, the Company entered into a three-year contract with a committed
two-year term with AT&T, Inc. for communications services. As part of that
contract, the Company is required to use $780,000 per year for the first two
years of the contract.
In September 2003, the Company entered into a five year lease for office space
for its headquarters in Albany, NY. The lease is for approximately 21,000 square
feet. The lease period is November 15, 2003 through November 14, 2008. The lease
has a five year renewal option. Annual rents will be $190,000 for years one and
two and $225,000 for years three through five.
14. Recent Accounting Pronouncements
In May 2003, the Financial Accounting Standards Board (FASB) issued Financial
Accounting Standard No. 150, Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity, (FAS No. 150). The Standard
establishes how an issuer classifies and measures certain financial instruments
with characteristics of both liabilities and equity. This Standard becomes
effective for any financial instruments entered into or modified after May 31,
2003. The Company does not expect the adoption of FAS No. 150, to have a
material effect on its financial statements.
In April 2003, the FASB issued financial Accounting Standard No. 149, amendment
of Statement 133 on Derivative Instruments and Hedging Activities, (FAS No.
149). This statement amends and clarifies financial accounting and reporting for
derivative instruments, including certain derivative instruments embedded in
other contracts, and other hedging activities entered into after June 30, 2003.
The Company does not expect the adoption of FAS No. 149, to have a material
effect on its financial statements.
In January 2003, the Financial Accounting Standards Board issued Interpretation
No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"). FIN 46
provides guidance that determines conditions as to whether consolidation of a
Variable Interest Entity is required. The requirements of FIN 46 are applicable
to preexisting entities as of the beginning of the first interim period ending
after December 15, 2003. Transition disclosure requirements of FIN 46 are
required in all financial statements of interim or annual periods ending after
February 1, 2003. The Company believes the adoption of this interpretation will
not have a material impact on its financial position, results of operations or
cash flows.
14
Item 2. Managements Discussion and Analysis of Financial Condition and Results
of Operations for the Three and Nine Months Ended September 30, 2003.
The following discussion should be read in conjunction with the accompanying
Financial Statements and Notes thereto.
Critical accounting policies.
Our discussion and analysis of results of operations, financial condition and
cash flows are based upon our financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States of
America (GAAP). The preparation of these financial statements requires us to
make estimates and judgments that effect the reported amounts of assets,
liabilities, revenues and expenses, and related disclosure of contingent assets
and liabilities. These estimates are evaluated on an on-going basis, including
those related to revenue recognition and allowance for doubtful accounts,
valuation to allocate the purchase price for a business combination, notes
receivable reserve and fair value of customer contracts on foreclosed loans,
intangible assets and goodwill, income taxes, and contingencies and litigation.
We base our estimates on historical experience and on various other assumptions
that are believed to be reasonable under the circumstances, the results of which
form the basis for making judgments about the carrying values of assets and
liabilities that are not readily apparent from other sources. Actual results may
differ from these estimates under different assumptions or conditions.
Revenue recognition and allowance for doubtful accounts.
All revenue is recognized on an accrual basis. Accounts receivable consists
primarily of amounts due from dealers and end-users located in the United
States. Credit is extended based upon an evaluation of the dealers and end-users
financial condition and credit history. Receivables that are deemed not
collectible have been provided for in the allowance for doubtful accounts. If
the dealers financial condition were to deteriorate, resulting in their
inability to make payments, additional allowances may be required.
Valuation to allocate purchase price for a business combination.
The allocation of purchase price related to the acquisition of IASI and
affiliates was finalized during the third quarter of 2003. The final valuation
reduced the amount allocated to customer contracts and, therefore, reduced the
amount expensed as contract amortization.
Notes receivable reserve and fair value of customer contracts on foreclosed
loans.
We make loans to dealers, which are collateralized by the dealers' portfolio of
end-user alarm monitoring contracts. Loans to dealers are carried at the lower
of the principal amount outstanding or if non-performing, the net realizable
value of the portfolio underlying the loan. Loans are generally considered
non-performing if they are 120 days in arrears of contractual terms.
Management periodically evaluates the loan portfolio to assess the
collectibility of dealer notes and adequacy of allowance for loan losses.
Management reviews certain criteria in assessing the adequacy of the allowance
for loan losses including our past loan loss experience, known and inherent
risks in the portfolio, adverse situations that may affect the borrower's
ability to repay, the estimated value of any underlying collateral and current
economic conditions. Loan impairment is identified when a portfolio's cash flow
is materially below the minimum necessary to service the loan. In most cases,
loans will be foreclosed and valued at the lower of cost (loan carrying value)
or fair value of end-user contracts using recent transaction prices and industry
benchmarks.
Notes receivable consists of loans to dealers which are collateralized by a
portfolio of individual end-user monitoring contracts. When a dealer becomes
delinquent, we generally foreclose on and take ownership of the portfolio of
end-user monitoring contracts.
15
Intangible assets and goodwill.
Alarm monitoring services for dealers' end-users are outsourced to us. We
acquire such dealer relationships from our internally generated sales efforts
and from other monitoring companies. Acquired dealer relationships are recorded
at cost which management believes approximates fair value. End-user alarm
monitoring contracts are acquired from the dealers' pre-existing portfolios of
contracts or assumed upon the foreclosure on dealers' loans.
Acquired end-user alarm monitoring contracts are recorded at cost which
management believes approximates fair value. End-user alarm monitoring contracts
assumed as a result of foreclosure on dealer loans are recorded at the lower of
cost (loan carrying value) or the fair value of such contracts using recent
transaction prices and industry benchmarks at the time of foreclosure.
End-user alarm monitoring contracts are amortized over the term that such
end-users are expected to remain a customer of the Company. The Company, on an
ongoing basis, conducts comprehensive reviews of its amortization policy for
end-user contracts and, when deemed appropriate, uses an independent appraisal
firm to assist in performing an attrition study.
Dealer relationships and customer (end-user) contracts are amortized using
methods and lives which are management's estimates, based upon all information
available (including industry data, attrition studies, current portfolio
trends), of the life (attrition pattern) of the underlying contracts and
relationships. If actual results vary negatively (primarily attrition) from
management assumptions, amortization will be accelerated which will negatively
impact results from operations. If amortization is not accelerated or conditions
deteriorate dramatically, the asset could become impaired. For existing
portfolio accounts purchased subsequent to January 31, 2003, the Company will
amortize such accounts using the straight-line method over an 18 year period
plus actual attrition. This methodology may cause significant variations in
amortization expense in future periods.
Dealer relationships and end-user alarm monitoring contracts are tested for
impairment on a periodic basis or as circumstances warrant. Recoverability of
dealer relationship costs and end-user alarm monitoring contracts are highly
dependent on our ability to maintain our dealers. Factors we consider important
that could trigger an impairment review include higher levels of attrition of
dealers and/or end-user alarm monitoring contracts and continuing recurring
losses.
SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets"
requires that the assets be reviewed for impairment whenever events or changes
in circumstances indicate that the carrying amount of an asset may not be
recoverable. Recoverability of the assets to be held and used is measured by a
comparison of the carrying amount of the assets with the future net cash flows
expected to be generated. Cash flows of dealer relationships and retail customer
contracts are analyzed at the same group level (acquisition by acquisition and
portfolio grouping, respectively) that they are identified for amortization, the
lowest level for which independent cash flows are identifiable. All other
long-lived assets are evaluated for impairment at the company level, using one
asset grouping. If such assets are considered to be impaired, the impairment to
be recognized is measured by the amount by which the carrying amount of the
assets exceeds the fair value of the assets.
Goodwill was being amortized on a straight-line basis over its estimated useful
life of 15 years through December 31, 2001. Effective January 1, 2002, we
adopted SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS 142 changed
the accounting for goodwill from an amortization method to an impairment-only
approach. An initial transition impairment test of goodwill was required as of
January 1, 2002. We completed this initial transition impairment test during the
third quarter of 2002, which did not result in any impairment charges. Our
annual impairment test was performed in the third quarter of 2003 and did not
result in any impairment charges.
Income taxes.
As part of the process of preparing our financial statements, we will be
required to estimate our income taxes in each of the jurisdictions in which we
operate. This process will involve estimates of our actual current tax exposure
together with assessing temporary differences resulting from differing treatment
of items, such as depreciation and amortization, for tax and accounting
purposes.
16
Contingencies and litigation.
In March 2003, Protection One Alarm Monitoring, Inc., ("Protection One") a
company engaged in the business of providing security and other alarm monitoring
services to residential and commercial customers, brought an action against the
Company in the Superior Court of New Jersey, Camden County for unspecified
damages in connection with the Company's purchase of certain alarm monitoring
contracts from B&D Advertising Corporation ("B&D"). B&D had previously sold
alarm monitoring contracts to Protection One. As part of such sales, B&D agreed
not to solicit any customers whose contracts had been purchased and to keep
certain information confidential. Protection One claims that the Company's
subsequent purchase of contracts from B&D constitutes tortious interference,
that the Company utilized confidential information belonging to Protection One
and that Protection One had an interest in some of the contracts that the
Company purchased from B&D. The Company plans to vigorously defend this claim.
The Company believes the resolution of this matter will not have a material
adverse effect on its financial condition, results of operations or cash flows.
In May 2003, a former employee of McGinn, Smith & Co., Inc., brought an action
against the Company, as well as McGinn, Smith & Co., Inc. and M&S Partners for
wrongful termination. The suit brought in the Supreme Court of the State of New
York seeks damages of $10,000,000. In August 2003, we filed a motion to dismiss
the claim against us, which was opposed by the plaintiff on August 27, 2003. The
Court's decision on the motion is still pending. McGinn, Smith & Co., Inc. and
M&S Partners have fully indemnified the Company from any damages or legal
expenses that the Company may incur as a result of the suit. This employee of
McGinn, Smith & Co., Inc. was never the Company's employee and the Company plans
to vigorously defend this claim. The Company believes the resolution of this
matter will not have a material adverse effect on its financial condition,
results of operations or cash flows.
The Company is involved in litigation and various legal matters that have arisen
in the ordinary course of business. The Company does not believe that the
outcome of these matters will have a material adverse effect on the Company's
financial position, results of operations or cash flows.
Results of operations
Three months ended September 30, 2003 compared to the three months ended
September 30, 2002.
Revenue.
Total revenue for the three months ended September 30, 2003 was approximately
$9,732,000 compared to approximately $5,789,000 for the same period during the
prior year, an increase of approximately $3,943,000, or 68.1%.
Wholesale monitoring revenues increased from approximately $4,970,000 in the
third quarter of 2002 to approximately $5,930,000 for the same period in 2003,
an increase of approximately $960,000, or 19.3%. The increase is due, in part,
to an increase in accounts contributing incremental revenue of approximately
$722,000. The balance of the increase in revenue, or approximately $238,000, is
due to an increase in average revenue per account per month from $3.99 for the
three months ended September 30, 2002 to $4.15 for the comparable period of
2003. The net increase in accounts can be attributed primarily to the
acquisition of approximately 80,000 accounts as a result of the purchase of
Criticom, offset, in part, by a net loss of approximately 18,000 dealer and
end-user accounts through attrition. The majority of this attrition is believed
to have been the result of our central station consolidation and monitoring
system conversion program. The net loss of approximately 18,000 accounts
represents approximately $77,000 of recurring monthly revenue, a loss that has
been offset by monthly expense savings totaling approximately $200,000 in
connection with our central station consolidation and monitoring system
conversion programs. The total number of end-user accounts monitored at
September 30, 2003, was approximately 475,000.
Revenues for our retail operations, which we acquired during January 2003,
totaled approximately $3,680,000 for the three months ended September 30, 2003.
Other revenue, which includes billing and placement fees and service and
subcontractor fees, totaled approximately $122,000,a decrease of approximately
$697,000 compared with same period last year. The decrease is due primarily to
the cessation of the recognition of related party placement fees as a result of
the merger of IASI and affiliates.
17
Cost of Revenue.
Our cost of revenue for the three months ended September 30, 2003 was
approximately $4,248,000 compared with approximately $3,445,000 for the same
period last year, an increase of approximately $803,000. This increase in cost
of revenue for the three months ended September 30, 2003 was primarily due to
approximately $759,000 of costs associated with Criticom, which we acquired
during September 2002, with the balance of approximately $44,000 being comprised
of approximately $72,000 of additional costs associated with IASI, which was
acquired in January 2003, offset, in part, by cost reductions of approximately
$28,000 in our wholesale monitoring operations.
Direct margin, including Criticom's operations, increased from 40.5% during the
three months ended September 30, 2002 to 56.4% for the same period during 2003.
As a result of the acquisition of IASI and affiliates in January 2003,
incremental revenues for the three months ended September 30, 2003 of
approximately $3,301,000 were earned. This incremental revenue was due to
customer contract revenue billed at approximately $29.95 versus monitoring
revenue billed to IASI, prior to the merger, at approximately $3.00 per customer
contract per month. Additionally, IASI's customer contract revenue has little
cost of revenue and, therefore, most of IASI's expenses are categorized as
operating expenses. As a result of the incremental margin associated with the
IASI merger, the direct margin for the three month period ended September 30,
2003 improved by 22.4% as compared to the direct margin without the IASI
incremental margin.
Operating Expenses.
Operating expenses increased from approximately $2,280,000 to approximately
$5,091,000, an increase of approximately $2,811,000, or 123.3%. The increase was
due to our acquisitions of IASI and Criticom, which added expenses totaling
approximately $2,803,000 and approximately $463,000, respectively, offset, in
part, by a reduction in the general and administrative expenses in the wholesale
monitoring segment.
Selling and marketing expenses increased approximately $64,000 from
approximately $165,000 to approximately $229,000 for the three month periods
ended September 30, 2002 and 2003, respectively. The increase was due to
additional expenses of approximately $149,000 resulting from the Criticom
acquisition, offset, in part, by decreases in salaries, trade show and other
expenses of approximately $27,000, $26,000 and $32,000, respectively.
Depreciation and amortization expenses increased from approximately $1,284,000
to approximately $2,189,000, an increase of approximately $905,000. This
increase was primarily a result of the consolidation of IASI's amortization
expenses totaling approximately $902,000. In the third quarter of 2003, the
allocation of the purchase price related to the acquisition of IASI and
affiliates was finalized. This final valuation reduced the amount allocated to
customer contracts and, therefore, reduced the amount expensed as contract
amortization for the three month period ending September 30, 2003 by
approximately $1,308,000.
General and administrative expenses increased from approximately $831,000 to
approximately $2,673,000, or approximately $1,842,000. The increase is due, in
part, to additional expenses of approximately $1,901,000 and $165,000 associated
with the acquisitions of IASI and Criticom, respectively, $180,000 of D & O
insurance expense, offset, in part, by reductions in professional fees in the
amount of approximately $86,000 and other expenses of approximately $318,000.
IASI's general and administrative expenses for the three months ended September
30, 2003 included: payroll and employee benefits related expenses of
approximately $590,000; bad debt expense of approximately $574,000; accounting
and professional fees of approximately $241,000; service fees of approximately
$178,000; bank charges and lock box fees of approximately $76,000; postage of
approximately $52,000; travel and entertainment expense of approximately
$47,000; and, other expenses of approximately $143,000. General and
administrative expenses for the third quarter of 2003 included accounting fees
related to our initial public offering activities of approximately $368,000.
Other Income/Loss.
Other income for the three months ended September 30, 2003 of approximately
$468,000 compares to other income for the same period in year 2002 of
approximately $113,000. For the most part, the period over period increase is
due to a settlement related to the acquisition of RTC Alarm Monitoring Services
(RTC), of approximately $375,000 and dissolution of certain liabilities related
to the RTC acquisition of approximately $142,000.
18
Amortization of Debt Issuance Costs.
The amortization of debt issuance costs increased approximately $1,655,000 from
approximately $331,000 for the three months ended September 30, 2002 to
approximately $1,986,000 for the same period in 2003. Approximately $1,437,000
of the increase is due to the acceleration of amortization related to retired
debt. The total accelerated amortization for the third quarter of 2003 is
approximately $1,556,000. The balance of the increase, or approximately
$218,000, is due to the of expense associated with the acquisition of IASI of
approximately $316,000, offset, in part, by a reduction in the expense in the
wholesale monitoring segment of approximately $98,000.
Interest Expense, Net of Interest Income.
Interest expense, net of interest income, increased by approximately $2,195,000
from approximately $1,083,000 to approximately $3,278,000. In the wholesale
monitoring business, interest expense, net of interest income, decreased from
approximately $1,083,000 to approximately $547,000, or 49.5%, while IASI's
interest expense, net of interest income, totaled approximately $2,731,000.
Taxes.
Income tax benefit totaled approximately $583,000 for the three months ended
September 30, 2002 compared with a benefit of approximately $36,000 for the
three months ended September 30, 2003. The income tax benefit recorded during
the three months ended September 30, 2002 and 2003, did not reflect merger or
acquisition related adjustments.
Nine months ended September 30, 2003 compared to the nine months ended September
30, 2002
Revenue.
Total revenue for the nine months ended September 30, 2003 was approximately
$28,249,000 compared to approximately $16,778,000 for the same period during the
prior year, an increase of approximately $11,471,000 or 68.4%.
Wholesale monitoring revenues increased from approximately $15,395,000 in the
nine months ended September 30, 2002 to approximately $18,155,000 for the same
period in 2003, an increase of approximately $2,760,000. The increase is due
primarily to a net increase in accounts of approximately 62,000 since September
30, 2002 which contributed incremental revenue of approximately $2,646,000. The
balance of the increase in revenue, or approximately $114,000, is due to an
increase in average revenue per account per month from $4.17 for the nine months
ended September 30, 2002 to $4.20 for the comparable period of 2003. The net
increase in accounts can be attributed primarily to the acquisition of
approximately 80,000 accounts as a result of the purchase of Criticom, offset,
in part, by a net loss of approximately 18,000 dealer and end-user accounts
through attrition. The majority of this attrition is believed to have been the
result of our central station consolidation and monitoring system conversion
program. The loss of revenue associated with this attrition has been offset by
the realization of expense savings from central station consolidation and
monitoring system conversion programs.
Revenues for our retail operations, which we acquired with our purchase of IASI
during January 2003, totaled approximately $9,747,000 for the nine months ended
September 30, 2003. IASI acquires alarm monitoring contracts from dealers and
owned approximately 40,000 end-user agreements at September 30, 2003.
Other revenue, which includes billing and placement fees and service and
subcontractor revenue, totaled approximately $347,000, a decrease of
approximately $1,036,000 compared with the prior year. The decrease is due
primarily to the cessation of the recognition of related party placement fees as
a result of the merger of IASI and affiliates.
19
Cost of Revenue.
Our cost of revenue totaled approximately $12,001,000, an increase of
approximately $827,000 from the same period of the prior year. For the most
part, this increase is comprised of an increase of approximately $2,186,000
associated with the acquisition of Criticom, offset by expense reductions of
approximately $1,359,000 resulting from increased synergy achieved through the
consolidation and monitoring system conversion program. IASI's customer contract
revenue has little cost of revenue and, therefore, most of IASI's expenses are
categorized as operating expenses. As a result of the acquisition of IASI and
affiliates in January 2003, incremental revenues for the nine months ended
September 30, 2003 of approximately $8,723,000 were earned. This incremental
revenue was due to customer contract revenue billed at approximately $29.95
versus monitoring revenue billed to IASI, prior to the merger, at approximately
$3.00 per customer contract per month. This incremental revenue improved the
direct margin for the the same nine month period by 19.0%.
Operating Expenses.
Operating expenses increased from approximately $5,981,000 to approximately
$20,089,000, or approximately $14,108,000. The increase was due primarily to the
incremental expenses associated with the acquisitions of Criticom, during
September 2002, and IASI, during January 2003 in the amounts of approximately
$1,298,000 and $12,844,000, respectively.
Selling and marketing expenses increased approximately $182,000, from
approximately $503,000 to approximately $685,000, or 36.2%. For the nine months
ended September 30, 2003, Criticom added approximately $216,000 to our selling
and marketing expenses which accounted for the year over year increase. This
incremental amount was comprised of salary expense of approximately $189,000,
travel and lodging of approximately $12,000 and other expenses totaling
approximately $15,000.
Depreciation and amortization expenses increased from approximately $3,952,000
to approximately $8,609,000, an increase of approximately $4,657,000. This
increase was primarily a result of the consolidation of IASI's amortization
expenses totaling approximately $4,644,000.
General and administrative expenses increased from approximately $1,526,000 to
approximately $10,795,000, or approximately $9,269,000 for the nine months ended
September 30, 2003. The largest component of this increase relates to the
consolidation of IASI's general and administrative expenses totaling
approximately $8,200,000. IASI's general and administrative expenses included,
in part: assumption of debt from CCCC in the amount of $1,825,000; a cash
payment to CCCC of $1,700,000; payroll and employee benefits related expenses
totaling approximately $1,367,000; bad debt expense totaling approximately
$1,024,000; accounting fees of approximately $967,000, the vast majority of
which are related to initial public offering activity; bank, lock box and line
of credit commitment fees of approximately $336,000; professional and billing
services fees totaling approximately $294,000; service expenses of approximately
$214,000; and, postage expense of approximately $168,000. The balance of the
increase in the Company's general and administrative expenses for the nine
months ended September 30, 2003 can be attributed to an increase in general and
administrative expenses for the wholesale monitoring operations which was
comprised, in part, of approxmiately $434,000 of additional expenses resulting
from the acquisition of Criticom, professional fees of approximately $244,000,
$180,000 of D & O insurance expense and salary and payroll taxes of
approximately $66,000.
Other Income/Loss.
Other income for the nine months ended September 30, 2003 was approximately
$205,000, due primarily to the RTC settlement of approximately $375,000. For the
comparable period of 2002 other income was approximately $1,035,000, which, for
the most part, arose from the forgiveness of debt in connection with a
litigation settlement for an uncompleted merger of approximately $922,000.
Amortization of Debt Issuance Costs.
The amortization of debt issuance costs increased approximately $2,132,000 from
approximately $761,000 to approximately $2,893,000. Approximately $1,437,000 of
the increase is due to the acceleration of amortization related to debt retired
during the third quarter of 2003. The total accelerated amortization for the
third quarter of 2003 is approximately $1,556,000. The balance of the increase,
or approximately $695,000, is due to the approximately $969,000 of expense
associated with the acquisition of IASI, offset, in part, by a reduction in the
expense in the wholesale monitoring segment of approximately $274,000.
20
Interest Expense, Net of Interest Income.
Interest expense, net of interest income, increased by approximately $7,025,000
from approximately $3,596,000 to approximately $10,621,000. In the wholesale
monitoring businesses, interest expense, net of interest income, decreased from
approximately $3,596,000 to approximately $3,154,000, or 12.3%. IASI's interest
expense, net of interest income, totaled approximately $7,467,000.
Taxes.
Income tax expense of approximately $3,331,000 was recorded in the current
period as compared to an income tax benefit of approximately $551,000 during the
same period last year. As a result of the merger of KC Acquisition with IASG
during January 2003, KC Acquisition, KCF, Morlyn and Criticom will no longer be
considered flow through entities to their shareholders and members and,
therefore, must record current and deferred income taxes from it's earnings and
losses, and recognize the tax consequences of "temporary differences" between
financial statement and the tax basis of existing assets and liabilities. At the
time of the change in tax status of the enterprise, the Company recorded an
additional deferred tax liability of approximately $3,505,000, which is being
included in income tax expense in 2003. In the wholesale monitoring businesses,
the prior period tax benefit reflected the change in the deferred tax liability
net of S corporate taxes.
Results of Operations by Segment
The comparable financial results for the Company's two operating segments;
Alarm-Monitoring, Wholesale Services and Alarm-Monitoring, Retail Services for
the nine month period ended September 30, 2003 as compared to the same period
during 2002 as well as the three months ended September 30, 2003 compared with
the three months ended September 30, 2002 are discussed below. The Company
purchased its Retail Services segment during January 2003 and as a result, data
is not available for the comparable periods during 2002.
Alarm Monitoring, Wholesale Segment. Three month ended September 30, 2003.
Alarm Monitoring, Wholesale segment total revenue increased approximately
$263,000, or 4.5%, to approximately $6,052,000 for the three months ended
September 30, 2003 from approximately $5,789,000 for the same period in 2002.
The increase in revenue was due primarily to the acquisition of Criticom,
offset, in part, by a reduction in other revenues resulting from the cessation
of the recognition of related party placement fees as a result of the merger of
IASI and affiliates.
Direct margin as a percent of total revenue was 31.0% for the three months ended
September 30, 2003 compared with 40.5% for the three months ended September 30,
2002. Income from operations totaled approximately $69,000 for the three months
ended September 30, 2003 compared with a income of approximately $64,000 for the
same period last year.
The segment's loss before income taxes decreased from approximately $1,236,000
for the three months ended September 30, 2002 to approximately $933,000 for the
comparable three months period in 2003.
Alarm Monitoring, Wholesale Segment. Nine months ended September 30, 2003.
Alarm Monitoring, Wholesale segment revenue for the nine months ended September
30, 2003 totaled approximately $18,502,000 compared to $16,778,000 for the
comparable period during 2002, an increase of $1,724,000, or 10.3%.
Direct margin increased from 33.4% for the nine months ended September 30, 2002
to 36.0% for the nine months ended September 30, 2003. Operating results
improved from a loss from operations of approximately $377,000 for the 2002
period to income from operations of approximately $1,065,000 for the same period
in 2003.
Alarm Monitoring, Retail Segment Three months ended September 30, 2003.
Alarm Monitoring, Retail segment revenue totaled approximately $3,680,000 for
the three months ended September 30, 2003.
The segment's income from operations totaled approximately $325,000, while the
loss before income taxes totaled approximately $3,469,000.
21
Alarm Monitoring, Retail Segment Nine months ended September 30, 2003
Alarm Monitoring Retail segment revenue totaled approximately $9,747,000 for the
nine months ended September 30, 2003. The segment's loss from operations totaled
approximately $4,907,000, while the loss before income taxes totaled
approximately $14,090,000.
Liquidity and Capital Resources.
The balance sheet at September 30, 2003 reflects working capital of
approximately $87.9 million. As of September 30, 2003, notes receivable and
customer contracts totaled approximately $36.8 million, the majority of which
was acquired as part of the IASI acquisition in January 2003. Total debt had
increased to approximately $67.3 million as of September 30, 2003. Approximately
$61.8 million of that debt was acquired as a result of the IASI acquisition.
These debt balances are after initial public offering proceeds of $91.9 million
were used to pay-off existing debt in the third quarter of 2003.
On July 29, 2003, the Company successfully completed its initial public
offering. A total of 22,000,000 shares of common stock were issued at a per
share price of $9.25. The net proceeds to the Company after underwriting
commissions (7%) and other direct initial public offering costs were
approximately $187,403,000. The common stock trades on the NASDAQ National
Market under the symbol "IASG".
On August 27, 2003, the underwriters exercised a portion of their overallotment
option and an additional 982,729 shares of common stock were issued at a per
share price of $9.25. The proceeds to the Company after underwriting commissions
(7%) were approximately $8,454,000.
During 2003, we were in default of our monthly and quarterly financial and
non-financial debt covenants under our various debt agreements with LaSalle Bank
N.A., Key Bank National Association (Key Bank) and SLP Capital. The Key Bank and
SLP Capital debts were paid-off with proceeds from the initial public offering
during August 2003.
On May 9, 2003 we received a permanent bank waiver from LaSalle through April 1,
2003 for certain past covenant violations. With respect to an attrition
covenant, the Company has provided LaSalle with a security interest in
approximately $136,000 of additional alarm contract recurring monthly revenue.
After giving effect to the waivers decribed above, we are not currently in
default of our covenants.
In June 2003, the Company secured a $20 million account acquisition facility
with LaSalle Bank N.A., which was contingent upon the completion of an initial
public offering with minimum net proceeds of $115 million. The facility is
available to IASG for acquisitions of security alarm companies and pools of
security alarm contracts. The facility has not been closed in spite of the
completion of the initial public offering due to the Company's revised plan to
secure a larger syndicated facility, with LaSalle Bank N.A. as lead lender, at
more favorable terms.
The following is our debt payments due by period (in millions) as of September
30, 2003:
2007 &
Total 2003 2004 2005 2006 Thereafter
-------------------------------------------------------------------
Debt $ 67.3 $ 1.0 $ 18.7 $ 9.1 $ 3.8 $ 34.7
===================================================================
Our capital expenditures anticipated over the next twelve months include
equipment and software of approximately $ 2.5 million and our strategy to
purchase monitoring contracts, which we anticipate to be approximately $149.4
million. This strategy is dependent on obtaining additional financing.
In September 2003, the Company entered into a five year lease for office space
for its headquarters in Albany, NY. The lease is for approximately 21,000 square
feet. The lease period is November 15, 2003 through November 14, 2008. The lease
has a five year renewal option. Annual rents will be $190,000 for years one and
two and $225,000 for years three through five.
22
Recent Accounting Pronouncements
In May 2003, the Financial Accounting Standards Board (FASB) issued Financial
Accounting Standard No. 150, Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity, (FAS No. 150). The Standard
establishes how an issuer classifies and measures certain financial instruments
with characteristics of both liabilities and equity. This Standard becomes
effective for any financial instruments entered into or modified after May 31,
2003. The Company does not expect the adoption of FAS No. 150, to have a
material effect on its financial statements.
In April 2003, the FASB issued financial Accounting Standard No. 149, amendment
of Statement 133 on Derivative Instruments and Hedging Activities, (FAS No.
149). This statement amends and clarifies financial accounting and reporting for
derivative instruments, including certain derivative instruments embedded in
other contracts, and other hedging activities entered into after September 30,
2003. The Company does not expect the adoption of FAS No. 149, to have a
material effect on its financial statements.
In January 2003, the Financial Accounting Standards Board issued Interpretation
No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"). FIN 46
provides guidance that determines conditions as to whether consolidation of a
Variable Interest Entity is required. The requirements of FIN 46 are applicable
to preexisting entities as of the beginning of the first interim period ending
after December 15, 2003. Transition disclosure requirements of FIN 46 are
required in all financial statements of interim or annual periods ending after
February 1, 2003. The Company believes the adoption of this interpretation will
not have a material impact on its financial position, results of operations or
cash flows.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to market risk is limited to interest income and expense
sensitivity, which is effected by changes in the general level of interest
rates. The primary objective of our investment activities is to preserve
principal while at the same time maximizing the income we receive without
significantly increasing risk. To minimize risk, we maintain our portfolio of
cash, cash equivalents and short-term and restricted investments in a variety of
interest-bearing instruments included United States government and agency
securities, high-grade United States corporate bonds, municipal bonds,
mortgage-backed securities, commercial paper and money market accounts at
established financial institutions. Due to the nature of our short-term and
restricted investments, we believe that we are not subject to any material
market risk exposure. We do not have any foreign currency. At September 30,
2003, we had approximately $1.8 million of variable rate debt all of which has
been fixed with an interest rate swap arrangement.
ITEM 4. CONTROLS AND PROCEDURES
We maintain disclosure controls and procedures that are designed to ensure that
information required to be disclosed in our Exchange Act reports is recorded,
processed, summarized and reported within the time periods specified in the
Securities and Exchange Commission's rules and forms and that such information
is accumulated and communicated to our management, including our CEO, COO and
CFO, as appropriate, to allow for timely decisions regarding required
disclosure. In designing and evaluating the disclosure controls and procedures,
management recognizes that any controls and procedures, no matter how well
designed and operated, can provide only reasonable assurance of achieving the
desired control objectives, and management is required to apply its judgment in
evaluating the cost-benefit relationship of possible controls and procedures.
As required by SEC Rule 13a-15(b), we carried out an evaluation, under the
supervision and with the participation of our management, including our CEO, COO
and CFO, of the effectiveness of the design and operation of our disclosure
controls and procedures as of the end of the quarter covered by this report.
Based on the foregoing, the CEO, COO and CFO concluded that our disclosure
controls and procedures were effective at the reasonable assurance level.
There has been no change in our internal controls over financial reporting
during the most recent fiscal quarter that has materially affected, or is
reasonably likely to materially affect, our internal controls over financial
reporting.
23
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In May 2003, a former employee of McGinn, Smith & Co., Inc., brought an action
against us, as well as McGinn, Smith & Co., Inc. and M&S Partners for wrongful
termination. The suit brought in the Supreme Court of the State of New York
seeks damages of $10,000,000. In August 2003, we filed a motion to dismiss the
claim against us, which was opposed by the plaintiff on August 27, 2003. The
Court's decision on the motion is still pending. McGinn, Smith & Co., Inc. and
M&S Partners have fully indemnified us from any damages or legal expenses that
we may incur as a result of the suit. This employee of McGinn, Smith & Co.,
Inc., was never our employee and we plan to vigorously defend this claim. We
believe the resolution of this matter will not have a material adverse effect on
our financial condition, results of operations or cash flows.
We from time to time experience routine litigation in the normal course of our
business. We do not believe that any pending litigation will have a material
adverse effect on our financial condition, results of operations or cash flows.
Other than the items previously disclosed, we are not a party in any other
material legal proceedings.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
The Company filed a Registration Statement (333-101159) with the Securities and
Exchange Commission on June 27, 2003 to register 25,300,000 shares of common
stock for sale at an aggregate offering price of approximately $278,300,000. The
offering commenced on July 23, 2003 and terminated on August 22, 2003. Upon
completion, the managing underwriter, Friedman, Billings, Ramsey & Co., Inc.,
successfully sold 22,982,729 shares at $9.25 per share for an aggregate offering
price of approximately $ 212,590,243. Concurrently with the offering, 792,793
shares of common stock were registered on behalf of certain holders of
convertible promissory notes. All of the shares of common stock were sold by us
and none of the selling security holders' shares were underwritten in the
offering.
Initial Public Offering Proceeds
Common Stock Issued $212,590,243
------------
Underwriter Commissions (7%) 14,881,317
Expenses paid to Underwriter 573,230
Other Expenses 1,279,184
------------
Total Expenses 16,733,731
------------
Net Offering Proceeds $195,856,512
============
Use of Proceeds (through September 30, 2003)
Repayment of debt $ 91,910,820
Acquisition of Contracts 1,419,843
Working Capital 2,920,856
------------
Total Uses $ 96,251,519
============
Temporary Investments
Certificate of Deposit (matures 10/27/03) $ 25,000,000
U.S. Government Agency Notes 66,828,806
Cash and Cash Equivalents 7,871,187
------------
Total Temporary Investments $ 99,699,993
============
24
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Not Applicable.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not Applicable.
ITEM 5. OTHER INFORMATION
Not Applicable.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
Exhibit 11.1: Statement of computation of earnings per share.
Exhibit 31. Rule 13a-14(a)/15d-14(a) Certifications.
Exhibit 32(a). Certification by the Chief Executive Officer Relating to a
Periodic Report Containing Financial Statements.*
Exhibit 32(b). Certification by the Chief Financial Officer Relating to a
Periodic Report Containing Financial Statements.*
* The Exhibit attached to this Form 10-Q shall not be deemed "filed" for
purposes of Section 18 of the Securities Exchange Act of 1934 (the "Exchange
Act") or otherwise subject to liability under that section, nor shall it be
deemed incorporated by reference in any filing under the Securities Act of 1933,
as amended, or the Exchange Act, except as expressly set forth by specific
reference in such filing.
(b) Reports on Form 8-K
None.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
November 13, 2003 INTEGRATED ALARM SERVICES GROUP, INC.
By: /s/ Timothy M. McGinn
-------------------------------
Name: Timothy M. McGinn
Title: Chief Executive Officer
By: /s/ Michael T. Moscinski
-------------------------------
Name: Michael T. Moscinski
Title: Chief Financial Officer
25