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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

x      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2010

or

o         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from             to            

1-12181-01

(Commission file number)

PROTECTION ONE, INC.

(Exact name of registrant

as specified in its charter)

Delaware

(State or other jurisdiction

of incorporation or organization)

93-1063818

(I.R.S. Employer Identification No.)

1035 N. Third Street, Suite 101

Lawrence, Kansas 66044

(Address of principal executive offices, including zip code)

(785) 856-5500

(Registrant’s telephone number,

including area code)

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 such registrants were required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.  Yes x  No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o  No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No x

The number of outstanding shares of the registrant’s common stock, $0.01 par value per share, as of May 11, 2010 was 25,435,221.

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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.  Statements that are not historical fact are forward-looking.  These forward-looking statements generally can be identified by, among other things, the use of forward-looking language such as the words “estimate,” “project,” “intend,” “believe,” “expect,” “anticipate,” “may,” “will,” “would,” “should,” “could,” “seeks,” “plans,” “intends,” or other words of similar import or their negatives.  Such statements include those made on matters such as our earnings and financial condition, the tender offer and proposed merger pursuant to our definitive agreement with affiliates of GTCR Golder Rauner II, L.L.C. (“GTCR”), litigation, accounting matters, our business, our efforts to consolidate and reduce costs, our customer account acquisition strategy and attrition, our liquidity and sources of funding and our capital expenditures.  All 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.  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, except as required by federal securities laws.  Certain factors that could cause actual results to differ include:

·                  our substantial indebtedness and restrictive covenants governing our indebtedness;

·                  our history of losses;

·                  effects from our entry into a definitive agreement to be acquired by an affiliate of GTCR;

·                  changes in technology that may make our services less attractive or obsolete or require significant expenditures to upgrade;

·                  loss of a relationship with alarm system manufacturers, suppliers and third party service providers;

·                  competition, including competition from companies that are larger than we are and have greater resources than we do;

·                  the development of new services or service innovations by our competitors;

·                  losses of our customers over time and difficulty acquiring new customers;

·                  changes in federal, state or local government or other regulations or standards affecting our operations;

·                  limited access to capital which may affect our ability to invest in the acquisition of new customers;

·                  the potential for environmental or man-made catastrophes in areas of high customer concentration;

·                  changes in conditions affecting the economy or security alarm monitoring service providers generally;

·                  potential liability for failure to respond adequately to alarm activations; and

·                  changes in management.

New factors emerge from time to time, and it is not possible for us to predict all factors or the impact of any factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.  For a discussion of these and other risks and uncertainties that could cause actual results to differ materially from those contained in our forward-looking statements, please refer to “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2009.

INTRODUCTION

Unless the context otherwise indicates, all references in this report to the “Company,” “Protection One,” “we,” “us” or “our” or similar words are to Protection One, Inc. and its wholly owned subsidiaries.  Protection One, Inc. is a Delaware corporation organized in September 1991.

Stockholders and other security holders or buyers of our securities or our other creditors should not assume that material events subsequent to the date of this report have not occurred.

On April 26, 2010, we entered into a definitive agreement (the “Merger Agreement”) to be acquired by Protection Holdings, LLC, an affiliate of GTCR. Under the terms of the Merger Agreement, Protection Acquisition Sub, Inc,. a newly formed entity and wholly owned subsidiary of Protection Holdings, LLC, commenced a tender offer on May 3, 2010 to acquire all of our outstanding common stock for $15.50 per share in cash (the “Offer”), to be followed by a merger (the “Merger”) to acquire all remaining outstanding shares at the same price paid in the Offer. The Offer will expire on June 2, 2010, unless extended in accordance with the terms of the Merger Agreement. The aggregate value of the proposed transaction is approximately $828 million. The completion of the Offer and Merger are subject to certain conditions and termination rights set forth in the Merger Agreement. See “Item 1A —Risk Factors.” The statements in this Quarterly Report on Form 10-Q are not a solicitation or recommendation of the Company to its stockholders in connection with the proposed tender offer, and stockholders should carefully review the Solicitation/Recommendation Statement on Schedule 14D-9 filed by the Company on May 3, 2010 and any amendments thereto before making any decision as to the tender offer.

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INDEX

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PART I — FINANCIAL INFORMATION

ITEM 1.     FINANCIAL STATEMENTS.

PROTECTION ONE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except for share and per share amounts)

(Unaudited)

The accompanying notes are an integral part of these

condensed consolidated financial statements.

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PROTECTION ONE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF

OPERATIONS AND COMPREHENSIVE LOSS

(in thousands, except for per share amounts)

(Unaudited)

The accompanying notes are an integral part of these

condensed consolidated financial statements.

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PROTECTION ONE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

The accompanying notes are an integral part of these

condensed consolidated financial statements.

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PROTECTION ONE, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 (Unaudited)

1.     Organization, Basis of Consolidation and Interim Financial Information:

Protection One, Inc. (the “Company”) is principally engaged in the business of providing security alarm monitoring services, including sales, installation and related servicing of security alarm systems for residential and business customers.  The Company also provides monitoring and support services to independent security alarm dealers on a wholesale basis.  Affiliates of Quadrangle Group LLC and Monarch Alternative Capital LP (collectively, the “Principal Stockholders”) own approximately 70% of the Company’s common stock.

The Company’s unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles, 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 GAAP 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, 2009 included in the Company’s Annual Report on Form 10-K, filed with the Securities and Exchange Commission, or the SEC, on March 24, 2010, as amended by the Form 10-K/A filed by the Company with the SEC on April 30, 2010.

In the opinion of management of the Company, all adjustments consisting of normal recurring adjustments considered necessary for a fair presentation of the financial statements have been included.  The results of operations presented for the three months ended March 31, 2010 and 2009 are not necessarily indicative of the results to be expected for the full year.

2.     Property and Equipment:

The following reflects the Company’s carrying value in property and equipment as of the following periods (in thousands):

Depreciation expense was $3.1 million for each of the three months ended March 31, 2010 and 2009, respectively.  The amount of fixed asset additions included in accounts payable was $0.1 million and $0.3 million as of March 31, 2010 and December 31, 2009, respectively.

Fixed Assets under Operating Leases

Rental equipment is comprised of commercial security equipment that does not require monitoring services by the Company and is leased to customers, typically over a 5-year initial lease term.  Accumulated depreciation of $4.3 million and $4.4 million was recorded on these assets as of March 31, 2010 and December 31, 2009, respectively.  Deferred revenue of $5.1 million was recorded at March 31, 2010 and will be amortized to income over the remaining lease term.  The following is a schedule, by year, of minimum future rental revenue on non-cancelable operating leases as of March 31, 2010 and does not include payments received at the inception of the lease which are deferred and amortized to income over the lease term (in thousands):

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3.    Goodwill and Intangible Assets:

The Company monitors for events or circumstances that may indicate potential impairment of goodwill and intangible assets each reporting period.  There were no such events or circumstances identified during the first quarter of 2010.  Fair value of the trade name in the Multifamily segment was approximately 9% in excess of carrying value.  The carrying value of the trade name was $1.9 million as of March 31, 2010.  A change in the discount rate, projected Multifamily revenue or royalty rate could result in future impairment.

During the three months ended March 31, 2010 and 2009, there was no change in the carrying value of goodwill or trade names, the Company’s indefinite-lived intangible assets.

The Company’s amortizable intangible assets are presented in the following table (in thousands):

Amortization expense was $8.0 million and $9.3 million for the three months ended March 31, 2010 and 2009, respectively.

The Company utilizes the declining balance method of amortization for its amortizable intangible assets.  The Company switches from the declining balance method to the straight-line method in the year the straight-line method results in greater amortization expense.  Amortization methods and lives for each pool of intangible assets are described in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.

The table below reflects the estimated aggregate amortization expense for 2010 (including amounts incurred in the first three months) and each of the four succeeding fiscal years on the existing base of amortizable intangible assets as of March 31, 2010 (in thousands):

4.     Accrued Liabilities:

The following reflects the components of accrued liabilities as of the periods indicated (in thousands):

5.     Debt and Capital Leases:

Long-term debt and capital leases are as follows (in thousands):

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Senior Credit Agreement

On November 17, 2009, the Company amended its senior credit agreement (as amended, the “Senior Credit Agreement”) which (i) increased term loan borrowings by $75 million under the New Term Loans to an aggregate of $364.5 million, (ii) divided all of its term loans into Non-Extending Term Loans equal to $86.5 million and New and Extending Term Loans equal to $278.0 million and (iii) replaced its $25 million revolving credit facility with a $15 million revolving credit facility.

The modification to the extending term loans of $203.0 million was considered a significant modification in accordance with ASC 470-50-40-10 and extinguishment accounting was therefore applied to $203 million of the original term loans.  The present value of the cash flows of the modified term loans was determined to be more than 10% greater than the present value of the cash flows of the original term loans primarily due to the increased interest rate on the modified debt which includes an increased interest rate margin of 2.0% and 2.0% LIBOR floor.  The interest rate on these term loans prior to the modification was 2.48%.  The interest rate at March 31, 2010, was 6.25% and 2.50% for the New and Extending Term Loans and the Non-Extending Term Loans, respectively.

The New and Extending Term Loans were recorded as new debt at fair value which was determined to be at 98% of par.  The fair value determination was based on the 2% discount on the issuance of the $75 million of New Term Loans which have the same terms and conditions as the $203.0 million of extending term loans.  Consequently, a debt discount of $5.6 million was recorded on the $278.0 million of New and Extending Term Loans.  The $203.0 million of original term loans were deemed to have been retired at the fair value of the modified term loans resulting in an extinguishment gain of $4.1 million which was partially offset by $0.6 million of fees paid directly to the lenders related to the amendment and $1.5 million of debt issue costs associated with the original debt for a net extinguishment gain of $2.0 million.  The Company capitalized $3.9 million of debt issue costs associated with the amendment to the Senior Credit Agreement in 2009.

Under the Senior Credit Agreement, the New and Extending Term Loans are scheduled to mature on March 31, 2014, provided, however, that the New and Extending Term Loans will mature on December 14, 2012 if prior to December 14, 2012, the maturity date of the unsecured term loan facility maturing March 14, 2013 (“Unsecured Term Loan”) is not extended to at least 91 days after March 31, 2014 or the borrowings under the Unsecured Term Loan Agreement are not refinanced with permitted refinancing indebtedness having a maturity date at least 91 days after March 31, 2014.  The New and Extending Term Loans bear interest at a margin of 4.25% over the Eurodollar Base Rate (as defined in the Senior Credit Agreement and subject to a 2% floor) for Eurodollar borrowings and 3.25% over the Base Rate (as defined in the Senior Credit Agreement and subject to a 3% floor) for Base Rate borrowings.  The Non-Extending Term Loans are still scheduled to mature on March 31, 2012 and bear interest at a margin of 2.25% over the Eurodollar Base Rate for Eurodollar borrowings and 1.25% over the Base Rate for Base Rate Borrowings.

Borrowings under the Senior Credit Agreement are secured by substantially all assets of the Company and require quarterly principal payments of $0.8 million and potential annual prepayments based on a calculation of “Excess Cash Flow,” as defined in the Senior Credit Agreement, due in the first quarter of each subsequent fiscal year.  The Company made $30.0 million in principal prepayments on the Non-Extending Term Loans in December 2009 which were applied toward the required Excess Cash Flow prepayment, resulting in no additional required prepayment in the first quarter of 2010.

Unsecured Term Loan

The Unsecured Term Loan bears interest at the prime rate plus 11.5% per annum and matures in 2013.   Interest is payable semi-annually in arrears on March 14 and September 14 of each year.  The annual interest rate was 14.75% at March 31, 2010.  The Unsecured Term Loan lenders include, among others, entities affiliated with the Principal Stockholders and Arlon Group.  Affiliates of the Principal Stockholders collectively owned approximately 70% of the Company’s common stock as of March 31, 2010, and one of the Company’s former directors is affiliated with Arlon Group.  The Company recorded $1.6 million of related party interest expense for each of the three months ended March 31, 2010 and 2009, respectively.

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Fair Value of Debt

The fair value of the Company’s debt instruments are estimated based on quoted market prices except for the Unsecured Term Loan, which had no available quote and was estimated by the Company based on the terms of the loan and comparison to fair value of its other debt.  At March 31, 2010 and December 31, 2009 the fair value and carrying amount of the Company’s debt were as follows (in thousands):

(a)          The March 31, 2010 fair value of the Unsecured Term Loan is estimated based on the Company’s expectation that the debt will be prepaid at par upon sale of the Company, which is anticipated to be completed in the second quarter of 2010.  The December 31, 2009 fair value of the Unsecured Term Loan is estimated by the Company based on the terms of the loan and comparison to fair value of its other debt.

The estimated fair values may not be representative of actual values of the financial instruments that could have been realized at period end or may be realized in the future.

Capital Leases

The Company acquired vehicles through capital lease agreements.  Accumulated depreciation on these assets as of March 31, 2010 and December 31, 2009 was $6.6 million and $6.2 million, respectively.  The following is a schedule of future minimum lease payments under capital leases together with the present value of net minimum lease payments as of March 31, 2010 (in thousands):

(a)  Reflected in the condensed consolidated balance sheet as current and non-current obligations under debt and capital leases of $1,847 and $1,080, respectively.

Debt Covenants

At March 31, 2010, the Company was in compliance with the financial covenants and other maintenance tests for all its debt obligations.  The Consolidated Leverage Ratio and Consolidated Interest Coverage Ratio contained in the Senior Credit Agreement are maintenance tests and the Consolidated Fixed Charge Coverage Ratio contained in the Unsecured Term Loan Agreement is a debt incurrence test.  The Company cannot be deemed to be in default solely due to failure to meet such debt incurrence tests.  However, failure to meet such debt incurrence tests could result in restrictions on the Company’s ability to incur additional ratio indebtedness.  The Company believes that should it fail to meet the minimum Consolidated Fixed Charge Coverage Ratio in its Unsecured Term Loan Agreement, its ability to borrow additional funds under other permitted indebtedness provisions of the Unsecured Term Loan Agreement and Senior Credit Agreement would provide sufficient liquidity for currently foreseeable operational needs.  The Company is prohibited from paying any cash dividends to stockholders under covenants contained in the Senior Credit Agreement.

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6.  Derivatives:

The Company holds one interest rate cap and three interest rate swaps to manage interest rate exposure on its variable rate borrowings.  The derivatives are accounted for as economic hedges of the Company’s debt subsequent to their de-designation which is further discussed below.  Prior to de-designation, the derivatives were considered cash flow hedges and changes resulting from fair market value adjustments were reflected in accumulated other comprehensive loss in the condensed consolidated balance sheet and as a component of unrealized other comprehensive loss in the condensed consolidated statement of operations and comprehensive loss.  Subsequent to de-designation, the derivatives are considered economic hedges and changes in fair value are recorded as interest expense.

The interest rate cap was entered into during the second quarter of 2005 as required by the Company’s then existing credit agreement.  The objective was to manage interest rate exposure caused by fluctuation in the LIBOR interest rate.  The cap provides protection on $75 million of the Company’s long term debt over a five-year period ending May 24, 2010 if LIBOR exceeds 6%.  In the second quarter of 2008, in connection with the interest rate swaps entered into and described below, the interest rate cap was de-designated as a cash flow hedge.  The cap had no fair value at March 31, 2010 or December 31, 2009.

The Company entered into three interest rate swaps in the second quarter of 2008 to fix the interest rate on $250 million of the variable rate debt under the Company’s then existing credit facility.  The interest rate swaps mature from September 2010 to November 2010.  The interest rate swaps were de-designated as cash flow hedges in conjunction with the debt refinancing that occurred in the fourth quarter of 2009.  See Note 5, “Debt and Capital Leases,” for additional discussion of the debt refinancing.

The fair value of the interest rate swaps are reflected in accrued liabilities.  At March 31, 2010 and December 31, 2009, the Company recorded $4.3 million and $5.7 million, respectively, in accrued liabilities.  The existing net unrealized loss on the interest rate swaps on the date of de-designation remains in accumulated other comprehensive loss and is amortized to interest expense as interest payments are made.  As of December 31, 2009 the amount of accumulated other comprehensive loss attributable to prior cash flow hedge relationships was $6.0 million.  During the quarter, $1.9 million of the accumulated loss was reclassified to interest expense.  The Company estimates the remaining $4.1 million of net unrealized loss in other comprehensive income at March 31, 2010 will be reclassified to earnings within the next twelve months.  The table below is a summary of the Company’s derivative positions as of March 31, 2010 and December 31, 2009 (in thousands):

Below is a summary of the amounts charged to interest expense and accumulated other comprehensive loss for the periods indicated (in thousands).  No ineffectiveness was recorded for any of the periods presented.

(a)          Interest rate swaps were de-designated as cash flow hedges in the fourth quarter of 2009.

(a)          Interest rate swaps were de-designated as cash flow hedges in the fourth quarter of 2009.

(b)         Interest rate caps were de-designated as cash flow hedges in the second quarter of 2008.

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7.  Fair Value Measurements:

The Company applies ASC 820, Fair Value Measurements and Disclosures, to determine fair value whenever other accounting pronouncements require or permit assets or liabilities to be measured at fair value.  ASC 820 establishes a fair value hierarchy that prioritizes the information used to develop assumptions used to determine the exit price.  ASC 820 also establishes valuation techniques that are used to measure fair value.  To increase consistency and comparability in fair value measurements and related disclosures, the fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three broad levels:

Level 1 — quoted prices in active markets for identical assets or liabilities;

Level 2 — directly or indirectly observable inputs other than quoted prices; and

Level 3 — unobservable inputs.

ASC 820 establishes a hierarchy which requires an entity to maximize the use of quoted market prices and minimize the use of unobservable inputs.  An asset or liability’s level is based on the lowest level of input that is significant to the fair value measurement.

The following table sets forth the Company’s financial assets and liabilities that were measured at fair value on a recurring basis by level within the fair value hierarchy at the dates identified (in thousands):

Marketable securities are included within cash and cash equivalents in the consolidated balance sheets, which generally consist of money market funds with original maturities less than 90 days and were measured using a level 1 fair value measurement with carrying value equal to fair value.  Derivatives consist of interest rate swap agreements and are valued using observable benchmark rates at commonly quoted intervals for the life of the instruments.

8.  Share-Based Employee and Director Compensation:

The Company accounts for share-based awards under generally accepted accounting principles which requires the measurement and recognition of compensation expense for all share-based payment awards to employees and directors based on estimated fair values.  Share-based compensation of $0.2 million and $0.3 million was recorded in general and administrative expense for the three month periods ended March 31, 2010 and 2009, respectively.  No tax benefit was recorded because the Company does not have taxable income and is currently fully reserving its federal deferred tax assets.  There were no amounts capitalized relating to share-based employee compensation in the three months ended March 31, 2010 or 2009.

On February 22, 2010 the Company granted equity awards to certain of the Senior Executives, consisting of (i) an aggregate of 439,160 stock appreciation rights (“SARs”) under the Company’s 2010 Stock Appreciation Rights Plan (the “2010 SAR Plan”), which was adopted by the Company on February 22, 2010; (ii) an aggregate of 439,160 stock options under the 2008 Long Term Incentive Plan (the “2008 LTIP”); and (iii) restricted share awards for an aggregate of 100,000 shares of restricted stock under the 2008 LTIP (collectively, the “equity awards”).  The exercise price for each stock option is $9.50, the closing price of the Company’s common stock on the date of grant.  The payout for each SAR is equal to the difference between (x) $7.50, and (y) the lesser of: (i) $9.50, the closing price of the Company’s common stock on the date of grant, and (ii) the value of a share of Company common stock on the date of exercise.  The equity awards vest in one-half increments on each of the second and third anniversary of the grant date so long as the Executive is employed with the Company.  Vesting of the equity awards will accelerate upon a change of control of the Company if (x) the Executive is employed with the Company at the time of the change of control or (y) the change of control occurs within two years of the date of grant and within 90 days of the Executive’s termination that is a qualifying termination (as defined in each Senior Executive’s amended and restated employment agreement).  Both the stock options and the restricted shares are subject to all the terms and conditions of the 2008 LTIP as well as the individual award agreements.  The SARs are subject to all of the terms and conditions of the 2010 SAR Plan as well as the individual grant agreements.

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The Company estimated fair value of the SARs using a Monte Carlo simulation valuation technique.  The Black-Scholes option-pricing model was used to estimate the fair value of options.  Key inputs in the valuation of the SARs and options were stock price volatility, expected term, and risk free rate.  The fair value of the awards granted totaled $2.7 million and will be recognized using a graded vesting method over the vesting period.  The SARs are liability awards and the fair value and related expense will be updated each reporting period.  Restricted shares were valued using the stock price on the date of grant.

For the three months ended March 31, 2010, the Company had 0.5 million share-based awards outstanding that represented dilutive potential shares.  These securities were not included in the computation of diluted loss per share because to do so would have been anti-dilutive for the period.  For the three months ended March 31, 2009, the Company had no stock options outstanding that represented dilutive potential shares.

9.     Commitments and Contingencies:

In addition to the matters described below, the Company is a defendant in a number of pending legal proceedings incidental to the normal course of its business and operations.  The Company does not expect the outcome of these proceedings, either individually or in the aggregate, to have a material adverse effect on the Company’s financial condition, results of operations or liquidity.

An estimate of the probable loss, if any, or the range of loss cannot be made for the following cases, and therefore, the Company has not accrued loss contingencies related to the following matters.

Scardino Litigation

On April 17, 2006, the Company was named a defendant in a litigation proceeding brought by Frank and Anne Scardino arising out of a June 2005 fire at their home in Villanova, Pennsylvania.  (Frank and Anne Scardino v. Eagle Systems, Inc., Eagle Monitoring, Inc. and Protection One Alarm Monitoring, Inc. d/b/a Dynawatch, Delaware County, Pennsylvania Court of Common Pleas, Cause No. 06-4485). The original complaint asserted six counts for negligence, gross negligence, breach of contract, breach of implied warranty of merchantability, breach of implied warranty of fitness for a particular purpose and violation of the Unfair Trade Practices and Consumer Protection Law (“UTPCPL”).  After extensive discovery, motion practice and multiple amendments to the plaintiffs’ complaint, the Company successfully reduced the plaintiffs’ claims to one count for breach of a written contract and three counts for breach of purported oral agreements.  Plaintiffs initially claimed direct and consequential damages in excess of $3 million but later claimed damages close to $5 million.

The Company notified its liability insurance carriers of the claim and was defending the remaining counts.  A settlement conference was held on March 1, 2010, at which a settlement was reached for an immaterial amount.  The settlement resolves all claims and counterclaims.  The terms of the settlement were agreed in writing and the parties have signed and exchanged a settlement agreement and mutual release.  The litigation was dismissed with prejudice on May 11, 2010.

By the Carat, Inc. Litigation

On April 30, 2007, IASG and certain of its subsidiaries, Criticom International Corporation and Monital Signal Corporation (collectively, the “Company defendants”), were served in a lawsuit brought by By the Carat, Inc. and John P. Humbert, Jr. and his wife, Valery Humbert, its owners, in connection with a December 2004 armed robbery of their jewelry business.  (By the Carat, Inc., John P. Humbert, Jr. and Valery Humbert v. Knightwatch Security Systems, Criticom International Corporation, Monital Signal Corporation, Integrated Alarm Services Group, Inc., et al, Superior Court of New Jersey, Monmouth County Law Division, Docket No.: MON-L-5830-06.) The complaint sought unspecified damages for alleged bodily injury and property losses based on various causes of action, including breach of contract, breach of the covenant of good faith and fair dealing, consumer fraud, intentional and negligent infliction of emotional distress, breach of warranty and gross negligence.

On June 26, 2009, the Court dismissed plaintiffs’ complaint without prejudice, due to the plaintiffs’ failure to comply with discovery orders.  Since the dismissal, plaintiffs have replaced their original counsel with new attorneys.  The new attorneys assisted the plaintiffs in complying with the outstanding discovery and the complaint was reinstated.

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Fact and expert discovery are complete.  In January 2010, the parties attempted to resolve the dispute through mediation.  The mediation was not successful, but the parties may revisit mediation in the future.  Subsequent to mediation, the Company defendants brought a motion for partial summary judgment as to plaintiffs’ property damage and consumer fraud claims.  The Court denied the motion for summary judgment on April 16, 2010.  The Court also denied a similar motion brought by the co-defendant.  Notably, the Company defendants have a contractual indemnification claim pending against that co-defendant.  In addition to its indemnification claim, the Company defendants have a number of defenses that it intends to pursue vigorously.  A trial date has not been set.

Paradox Litigation

On March 13, 2008, plaintiffs Paradox Security Systems, LTD., Samuel Hershkovitz and Pinhas Shpater filed a Second Amended Complaint in Civil Action No. 2:06-cv-462 in the Eastern District of Texas, Marshall Division, and added the Company as a defendant.  The complaint alleges that the Company infringes U.S. Patent No. 5,751,803 and U.S. Reissue Patent No. 39,406 (collectively, the “Patents-in-Suit”), by its sale and use of certain control panels made by Digital Security Controls, LTD. (“DSC”).  The Company answered the complaint by denying infringement, alleging invalidity and unenforceability of the Patents-in-Suit, and asserting other defenses and related declaratory judgment counterclaims.

At the April 2009 trial, the Court determined that the plaintiffs had not presented sufficient evidence to support plaintiffs’ allegations against the Company and the other defendants, and granted the defendants’ motions for judgment of non-infringement as a matter of law.

On September 14, 2009, final judgment was entered by the court, and on September 23, 2009, plaintiffs filed a notice of appeal to the Federal Circuit Court.  On December 21, 2009, plaintiffs filed their opening appellate brief, wherein they asserted that the trial court erred in entering judgments as a matter of law in favor of the defendants.  The Company’s reply brief, and the reply briefs of the other defendants, was filed in February 2010.  Oral arguments are scheduled to be conducted on June 7, 2010, and a final decision by the Federal Circuit Court is expected in late 2010.

Contract Settlement

The Company settled and accelerated termination of an existing operating lease agreement with the landlord at one of its branch facilities.  The Company has agreed to pay the landlord $1.525 million in satisfaction of all obligations under the lease agreement as a part of the settlement.  In connection with the exit of the lease agreement, the Company recorded an impairment charge of approximately $1.0 million primarily related to leasehold improvements at the facility during the three months ended March 31, 2010.

Shareholder Litigation

On May 6, 2010, Donald Rensch, a purported stockholder of Protection One, filed a complaint (the “Rensch Complaint”) on behalf of himself and as a putative class action on behalf of the Company’s public stockholders, against the Company, each member of the Company’s board of directors, Quadrangle Group LLC, POI Acquisition L.L.C., Monarch Alternative Capital LP, Protection Holdings, LLC, Protection Acquisition Sub, Inc. and GTCR Golder Rauner II, L.L.C. in the Court of Chancery of the State of Delaware (Donald Rensch v. Protection One, Inc. et al, C.A. No. 5468-VCS).  On May 10, 2010, Trading Strategies Fund, a purported stockholder of the Company, filed a complaint (the “TSF Complaint”) on behalf of itself and as a putative class action on behalf of the Company’s public stockholders, against the Company, each member of the Company’s board of directors and GTCR Golder Rauner II, L.L.C. in the district court of Douglas County, Kansas. On May 12, 2010, The Law Offices of Mark Kotlarsky Pension Plan, a purported stockholder of the Company, filed a complaint (the “Pension Plan Complaint”) on behalf of itself and as a putative class action on behalf of the Company’s public stockholders against the Company, each member of the Company’s board of directors, Quadrangle Group LLC, POI Acquisition, L.L.C., Monarch Alternative Capital LP, Protection Holdings, LLC, Protection Acquisition Sub, Inc. and GTCR Golder Rauner II, L.L.C. in the Court of Chancery of the State of Delaware. These complaints allege that the defendants breached their fiduciary duties or aided and abetted the alleged breach of fiduciary duties in connection with the Offer and the Merger contemplated by the Merger Agreement and alleges that the disclosures contained in the documents filed with the United States Securities and Exchange Commission by the Company (and Purchaser in the case of the Rensch Complaint) are materially misleading and omit material facts.  None of the complaints state how many shares of Company common stock are purportedly held by the respective plaintiffs.  The TSF Complaint seeks, among other things, declarations that the action brought by the complaint is properly maintainable as a class action, that certain of the defendants have breached their fiduciary duties to the named plaintiff and the class, that certain of the defendants aided and abetted breaches of fiduciary duty by other defendants, awarding of appropriate damages to the plaintiff and other members of the class, and awarding the plaintiff’s costs, including attorneys’ and experts’ fees.  The Rensch Complaint and the Pension Plan Complaint seek the same relief, and in addition, an order enjoining the transactions contemplated by the Merger Agreement.  The Company believes that the Rensch Complaint, the TSF Complaint and the Pension Plan Complaint are wholly without merit and intends to defend the cases vigorously.

Consumer Complaints

The Company occasionally receives notices of consumer complaints filed with various state agencies.  The Company has developed a dispute resolution process for addressing these administrative complaints.  The ultimate outcome of such matters cannot presently be determined; however, in the opinion of management, the resolution of such matters will not have a material adverse effect on the Company’s consolidated financial position, results of operations or liquidity.

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Funding Commitment

Notes receivable were $2.8 million and $2.9 million at March 31, 2010 and December 31, 2009, respectively, and represent loans to dealers collateralized by the dealers’ portfolios of customer monitoring contracts.  The Company has obligations to provide open lines of credit to dealers, subject to the terms of the agreements with the dealers.  At March 31, 2010 and December 31, 2009, the amount available to dealers under these lines of credit was $0.3 million and $0.2 million, respectively.

10.     Segment Reporting:

The Company organizes its operations into three business segments:  Retail, Wholesale and Multifamily.  The Company’s operating segments are defined as components for which separate financial information is available that is evaluated regularly by the chief operating decision maker.  The operating segments are managed separately because each operating segment represents a strategic business unit that serves different markets.  All of the Company’s reportable segments operate in the United States of America.

The Company’s Retail segment provides security alarm monitoring services, which include sales, installation and related servicing of security alarm systems for residential and business customers.  The Company’s Wholesale segment provides monitoring, financing and business support services to independent security alarm dealers.  The Company’s Multifamily segment 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 Annual Report on Form 10-K for the year ended December 31, 2009.  The Company manages its business segments based on earnings before interest, income taxes, depreciation, amortization (including amortization of deferred customer acquisition costs and revenue) and other items, referred to as Adjusted EBITDA.

Reportable segments (in thousands):

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

(2) Adjusted EBITDA, which is a non-GAAP measure, is used by the Company’s management and reviewed by the Board of Directors in evaluating segment performance and determining how to allocate resources across segments for investments in customer acquisition activities, capital expenditures and spending in general. The Company believes it is also utilized by the investor community which follows the security monitoring industry.  Adjusted EBITDA is useful because it allows investors and management to evaluate and compare operating results from period to period in a meaningful and consistent manner in addition to standard GAAP financial measures.  Specifically, Adjusted EBITDA allows the chief operating decision maker to evaluate segment results of operations, including operating performance of monitoring and service activities, effects of investments in creating new customer relationships, and sales and installation of security systems, without the effects of non-

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cash amortization and depreciation.  This information should not be considered as an alternative to any measure of performance as promulgated under GAAP, such as loss before income taxes or cash flow from operations.  Items excluded from Adjusted EBITDA are significant components in understanding and assessing the consolidated financial performance of the Company.  See the table below for the reconciliation of Adjusted EBITDA to consolidated loss before income taxes. The Company’s calculation of Adjusted EBITDA may be different from the calculation used by other companies and comparability may be limited.

Reconciliation of loss before income taxes to Adjusted EBITDA (in thousands):

(a)          Other costs in 2010 include $2.1 million related to the contract settlement as discussed in Note 9, Commitments and Contingencies.

11.  Income Taxes:

During the three months ended March 31, 2010, actual effective income tax expense differed from tax expense using the U.S. federal statutory tax rate of 35% primarily due to the impact of the deferred tax valuation allowance.  The Company recorded income tax expense of $0.7 million and $0.2 million for the three months ended March 31, 2010 and 2009, respectively.

Management believes the Company’s net federal deferred tax assets, including those related to net operating losses, are not likely realizable and therefore its net federal deferred tax assets are fully reserved.  In assessing whether deferred taxes are realizable, management considers whether it is more likely than not that some portion or all deferred tax assets will be realized.  The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible.  Management considers the Company’s projected future taxable income and tax planning strategies in making this assessment.

The Company has indefinite-lived intangible assets consisting of trade names and goodwill which are not amortized for financial reporting purposes.  These indefinite-lived intangible assets are tax deductible, and therefore, are amortized over fifteen years for tax purposes.  The tax-deductibility of these indefinite-lived intangible assets results in a deferred tax liability which only reverses at the time of impairment of the related asset or ultimate sale of the underlying intangible asset.  Due to the uncertain timing of this reversal, the difference cannot be considered as a source of future taxable income and cannot be used to offset the Company’s deferred tax assets.  As a result, the Company does not net such deferred tax liabilities against the Company’s deferred tax assets, which related primarily to net operating loss carry-forwards, when determining its valuation allowance.

12.  New Accounting Standards:

In November 2009, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update (“ASU”) 2009-13 and ASU 2009-14 on revenue arrangements with multiple deliverables and software revenue recognition.  ASU 2009-13 addresses the unit of accounting for arrangements involving multiple deliverables.  The guidance revises the determination of when the individual deliverables included in a multiple-element arrangement may be treated as separate units of accounting.  The guidance also revises the manner in which the transaction consideration is allocated across the separately identified deliverables.  ASU 2009-14 addresses revenue arrangements that contain both hardware elements and software elements.  ASU 2009-13 and ASU 2009-14 are effective for fiscal years beginning on or after June 15, 2010.  The Company is currently evaluating the impact, if any, adoption of ASU 2009-13 and ASU 2009-14 will have on its consolidated financial statements.

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13.  Subsequent Events:

On April 26, 2010, the Company entered into a definitive agreement to be acquired by Protection Holdings, LLC, an affiliate of GTCR. Under the terms of the Merger Agreement, Protection Acquisition Sub, Inc., a newly formed entity and wholly owned subsidiary of Protection Holdings, LLC, commenced a tender offer on May 3, 2010 to acquire all of the Company’s outstanding common stock for $15.50 per share in cash, to be followed by a Merger to acquire all remaining outstanding shares at the same price paid in the tender offer. The completion of the Offer and Merger are subject to certain conditions and termination rights of the parties set forth in the Merger Agreement.

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

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations updates the information provided in, and should be read in conjunction with, Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2009.

Overview

We believe we are the third largest provider of electronic security installation and monitoring in the United States, as measured by recurring monthly revenue, or RMR.  As of March 31, 2010, we served approximately 745,000 residential and business customers and monitored approximately 680,000 sites through our Wholesale operations.  Generating cash flow to fund growth and investment in new customers, as well as for debt service, is essential to our operations.

We organize our operations into the following three business segments:

Retail.  Our Retail segment provides monitoring and maintenance services for electronic security systems directly to residential and business customers. We also sell and install electronic security systems for homes and businesses through our Retail segment in order to meet their security needs.  As of March 31, 2010, we served approximately 534,000 retail customers across the nation, with no single customer comprising more than 1% of our total consolidated revenue.  Our Retail segment accounted for 80.2% of our recurring monthly revenue at March 31, 2010, of which approximately 30.4% was attributable to commercial customers.

Wholesale.  We contract with independent security alarm dealers nationwide to provide alarm system monitoring services to their residential and business customers.  As of March 31, 2010, our Wholesale segment served approximately 4,100 dealers by monitoring approximately 680,000 homes and businesses on their behalf.  We also provide business support services for these independent dealers including, in certain instances, financing in the form of loans secured by customer accounts.  Our top ten wholesale dealers, based on RMR, accounted for 28.9% of Wholesale monitored sites and 14.3% of Wholesale recurring monthly revenue as of March 31, 2010.

Multifamily.  We provide monitoring and maintenance services for electronic security systems to tenants of multifamily residences, including apartments, condominiums and other multifamily dwellings, under long-term contracts with building owners and managers.  We provided alarm monitoring services to approximately 211,000 units in nearly 475 cities as of March 31, 2010.

The table below identifies our consolidated revenue by segment for the periods presented (dollars in thousands):

Summary of Important Matters

Net Loss.  We incurred a net loss of $4.8 million and $2.8 million for the three months ended March 31, 2010 and 2009, respectively. The net loss in the three months ended March 31, 2010 and 2009 reflects (1) substantial charges incurred by us for amortization of customer accounts and previously deferred customer acquisition costs and interest incurred on indebtedness and (2) in the first quarter of 2010, a loss of $2.1 million in connection with an early termination of a lease agreement and related settlement payment and leasehold asset impairment.

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Due to business and consumer concerns regarding the U.S. economy as well as limited access to consumer credit, we identified fewer opportunities to sell security systems in 2009 compared to previous periods.  We believe security system sales have stabilized thus far in 2010.

Recurring Monthly Revenue.  We measure all of the RMR we are entitled to receive under contracts with customers in effect at the end of each reporting period.  Our computation of RMR may not be comparable to other similarly titled measures of other companies.  RMR should not be viewed by investors as an alternative to actual monthly revenue, as determined in accordance with generally accepted accounting principles, or GAAP, and is a non-GAAP measure.  RMR was $24.9 million and $26.5 million as of March 31, 2010 and 2009, respectively.  A significant portion of the decrease in RMR as of March 31, 2010 is a result of our agreement with APX, which resulted in a reduction of Wholesale RMR, as well as lower Retail investment in customer acquisition activities.

Each segment’s share of our total RMR and monitored sites at March 31 for the years presented were as follows:

Our RMR includes amounts billable to customers with past due balances which we believe are collectible. We seek to preserve the revenue stream associated with each customer contract, primarily to maximize our return on the investment we made to generate each contract.  As a result, we actively work to collect amounts owed to us and to retain the customer at the same time.  As a general rule, we accrue for the cancellation of customer RMR when a balance of more than one times the customer’s RMR becomes 120 days past due.  Exceptions to this rule are made when an evaluation of the ongoing customer relationship indicates that payment for the past due balance is likely to be received.

Even though our proportions of Retail, Wholesale and Multifamily RMR may differ significantly from other companies’ RMR mix, and contributions from each type of RMR vary, we believe the presentation of RMR is useful to investors because the measure is used by investors and lenders to value companies such as ours with recurring revenue streams.  Management monitors RMR, among other things, to evaluate our ongoing performance.  In order to enhance the investors’ understanding of the components of our RMR, we include roll-forwards for each segment below.  The table below reconciles our RMR to revenue reflected on our consolidated statements of operations (in thousands):

(a) Revenue that is not pursuant to monthly contractual billings.

The following table identifies RMR by segment and in total for the periods indicated (in thousands):