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 June 30, 2014

 

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 number 333-193639

 

APX Group Holdings, Inc.

(Exact name of Registrant as specified in its charter)

 

Delaware	46-1304852
(State or Other Jurisdiction of Incorporation or Organization)	(I.R.S. Employer Identification No.)

  

4931 North 300 West Provo, UT	84604
(Address of Principal Executive Offices)	(Zip Code)

 

Registrant’s Telephone Number, Including Area Code: (801) 377-9111

 

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 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  x    No  ¨

 

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.

 

Large accelerated filer	¨	Accelerated filer	¨
Non-accelerated filer	x  (Do not check if a smaller reporting company)	Smaller reporting company	¨

 

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

 

As of August 8, 2014, there were 100 shares of the issuer’s common stock, par value $0.01 per share, issued and outstanding.

 

 

 

  

APX Group Holdings Inc.

 

FORM 10-Q

 

TABLE OF CONTENTS

 

		Page
		No.

 

PART I — Financial Information		4
Item 1.	Unaudited Condensed Consolidated Financial Statements	4
	Unaudited Condensed Consolidated Balance Sheets as of June 30, 2014 and December 31, 2013	4
	Unaudited Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2014 and 2013	5
	Unaudited Condensed Consolidated Statements of Comprehensive Loss for the three and six months ended June 30, 2014 and 2013	6
	Unaudited Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2014 and 2013	7
	Notes to Unaudited Condensed Consolidated Financial Statements	8
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	30
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	49
Item 4.	Controls and Procedures	49
PART II — Other Information		50
Item 1.	Legal Proceedings	50
Item 1A.	Risk Factors	50
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	50
Item 3.	Defaults Upon Senior Securities	50
Item 4.	Mine Safety Disclosures	50
Item 5.	Other Information	51
Item 6.	Exhibits	51
SIGNATURES		52

 

  

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

This Quarterly Report on Form 10-Q includes forward-looking statements regarding, among other things, our plans, strategies and prospects, both business and financial. These statements are based on the beliefs and assumptions of our management. Although we believe that our plans, intentions and expectations reflected in or suggested by these forward-looking statements are reasonable, we cannot assure you that we will achieve or realize these plans, intentions or expectations. Forward-looking statements are inherently subject to risks, uncertainties and assumptions. Generally, statements that are not historical facts, including statements concerning our possible or assumed future actions, business strategies, events or results of operations, are forward-looking statements. These statements may be preceded by, followed by or include the words “believes,” “estimates,” “expects,” “projects,” “forecasts,” “may,” “will,” “should,” “seeks,” “plans,” “scheduled,” “anticipates” or “intends” or similar expressions.

 

Forward-looking statements are not guarantees of performance. You should not put undue reliance on these statements which speak only as of the date hereof. You should understand that the following important factors, in addition to those discussed in “Risk Factors” and elsewhere in this Quarterly Report, could affect our future results and could cause those results or other outcomes to differ materially from those expressed or implied in our forward-looking statements:

 

•

risks of the security and home automation industry, including risks of and publicity surrounding the sales, subscriber origination and retention process;

 

•

the highly competitive nature of the security and home automation industry and product introductions and promotional activity by our competitors;

 

•

litigation, complaints or adverse publicity;

 

•

the impact of changes in consumer spending patterns, consumer preferences, local, regional, and national economic conditions, crime, weather, demographic trends and employee availability;

 

•

adverse publicity and product liability claims;

 

•

increases and/or decreases in utility and other energy costs, increased costs related to utility or governmental requirements; and

 

•

cost increases or shortages in security and home automation technology products or components.

 

In addition, the origination and retention of new subscribers will depend on various factors, including, but not limited to, market availability, subscriber interest, the availability of suitable components, the negotiation of acceptable contract terms with subscribers, local permitting, licensing and regulatory compliance, and our ability to manage anticipated expansion and to hire, train and retain personnel, the financial viability of subscribers and general economic conditions.

 

These and other factors that could cause actual results to differ from those implied by the forward-looking statements in this Quarterly Report are more fully described in the “Risk Factors” section of our Annual Report on Form 10-K for the fiscal year ended December 31, 2013 and elsewhere in this Quarterly Report on Form 10-Q. The risks described in “Risk Factors” are not exhaustive. Other sections of this Quarterly Report describe additional factors that could adversely affect our business, financial condition or results of operations. New risk factors emerge from time to time and it is not possible for us to predict all such risk factors, nor can we assess the impact of all such risk factors 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. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the foregoing cautionary statements. We undertake no obligations to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise.

 

  

PART I. FINANCIAL INFORMATION

 

ITEM  1. UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

APX Group Holdings, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets (unaudited)

(In thousands)

 

		June 30, 2014				December 31, 2013
ASSETS
Current Assets:
Cash and cash equivalents		$	36,961			$	261,905
Short-term investments—other			60,058				-
Restricted cash and cash equivalents			14,214				14,375
Accounts receivable, net			10,720				2,593
Inventories, net			81,305				29,260
Prepaid expenses and other current assets			25,423				13,870
Total current assets			228,681				322,003
Property and equipment, net			44,841				35,818
Subscriber contract costs, net			440,059				288,316
Deferred financing costs, net			54,952				59,375
Intangible assets, net			772,663				840,714
Goodwill			836,702				836,318
Restricted cash and cash equivalents, net of current portion			14,214				14,214
Long-term investments and other assets, net			32,513				27,676
Total assets		$	2,424,625			$	2,424,434
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities:
Accounts payable		$	81,822			$	24,004
Accrued payroll and commissions			83,239				46,007
Accrued expenses and other current liabilities			33,409				33,118
Deferred revenue			31,727				26,894
Current portion of capital lease obligations			4,302				4,199
Total current liabilities			234,499				134,222
Notes payable, net			1,761,636				1,762,049
Liability—contracts sold, net of current portion			1,824				-
Capital lease obligations, net of current portion			7,869				6,268
Deferred revenue, net of current portion			26,284				18,533
Other long-term obligations			5,678				3,905
Deferred income tax liabilities			9,135				9,214
Total liabilities			2,046,925				1,934,191
Commitments and contingencies (See Note 13)
Stockholders’ equity:
Common stock			-				-
Additional paid-in capital			653,391				652,488
Accumulated deficit			(268,166	)			(154,615	)
Accumulated other comprehensive loss			(7,525	)			(7,630	)
Total stockholders’ equity			377,700				490,243
Total liabilities and stockholders’ equity		$	2,424,625			$	2,424,434

 

See accompanying notes to unaudited condensed consolidated financial statements 

 

  

APX Group Holdings, Inc. and Subsidiaries

Condensed Consolidated Statements of Operations (unaudited)

(In thousands)

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2014				2013				2014				2013
Revenues:
Monitoring revenue		$	128,602			$	108,646			$	253,156			$	211,015
Service and other sales revenue			4,719				5,322				9,553				27,315
Activation fees			878				284				1,644				364
Total revenues			134,199				114,252				264,353				238,694
Costs and expenses:
Operating expenses (exclusive of depreciation and amortization shown separately below)			47,216				38,435				88,533				84,128
Selling expenses			28,739				28,298				54,318				48,906
General and administrative expenses			35,326				24,910				60,461				45,249
Depreciation and amortization			53,364				46,338				103,716				92,132
Total costs and expenses			164,645				137,981				307,028				270,415
Loss from operations			(30,446	)			(23,729	)			(42,675	)			(31,721	)
Other expenses (income):
Interest expense			35,712				27,381				71,352				53,254
Interest income			(572	)			(396	)			(1,124	)			(676	)
Other (income) expenses, net			(52	)			(33	)			(297	)			317
Gain on 2GIG Sale			-				(46,643	)			-				(46,643	)
Loss before income taxes			(65,534	)			(4,038	)			(112,606	)			(37,973	)
Income tax expense			737				17,489				945				14,463
Net loss		$	(66,271	)		$	(21,527	)		$	(113,551	)		$	(52,436	)

  

See accompanying notes to unaudited condensed consolidated financial statements

 

  

APX Group Holdings, Inc. and Subsidiaries

Condensed Consolidated Statements of Comprehensive Loss (unaudited)

(In thousands)

 

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2014				2013				2014				2013
Net loss		$	(66,271	)		$	(21,527	)		$	(113,551	)		$	(52,436	)
Other comprehensive loss, net of tax effects:
Foreign currency translation adjustment			4,677				(4,368	)			105				(6,987	)
Total other comprehensive loss			4,677				(4,368	)			105				(6,987	)
Comprehensive loss		$	(61,594	)		$	(25,895	)		$	(113,446	)		$	(59,423	)

 

See accompanying notes to unaudited condensed consolidated financial statements

 

  

APX Group Holdings, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows (unaudited)

(In thousands)

 

		Six Months Ended June 30,
		2014				2013
Cash flows from operating activities:
Net loss		$	(113,551	)		$	(52,436	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Amortization of subscriber contract costs			23,238				4,866
Amortization of customer relationships			71,806				80,319
Depreciation and amortization of other intangible assets			8,672				6,947
Amortization of deferred financing costs			4,581				4,233
Fire related asset losses			2,846				-
Loss on asset impairment			1,351				-
Gain on sale of 2GIG			-				(46,643	)
Loss on sale or disposal of assets			10				293
Stock-based compensation			903				673
Provision for doubtful accounts			7,259				5,439
Paid-in-kind interest income			(910	)			(530	)
Non-cash adjustments to deferred revenue			117				905
Deferred income taxes			761				9,582
Changes in operating assets and liabilities, net of acquisitions and divestiture:
Accounts receivable			(15,358	)			(6,616	)
Inventories			(52,154	)			(25,874	)
Prepaid expenses and other current assets			(12,361	)			(4,492	)
Accounts payable			57,816				6,008
Accrued expenses and other liabilities			37,638				45,031
Deferred revenue			12,427				15,368
Net cash provided by operating activities			35,091				43,073
Cash flows from investing activities:
Subscriber acquisition costs			(174,567	)			(156,742	)
Capital expenditures			(12,057	)			(3,781	)
Proceeds from the sale of 2GIG, net of cash sold			-				143,262
Proceeds from the sale of property & equipment			-				9
Acquisition of intangible assets			(6,127	)			-
Net cash used in acquisitions			(3,500	)			(4,272	)
Investment in short-term investments—other			(60,000	)			-
Investment in convertible note			(3,000	)			-
Other assets			(35	)			(5,660	)
Net cash used in investing activities			(259,286	)			(27,184	)
Cash flows from financing activities:
Proceeds from notes payable			-				203,500
Repayments of revolving line of credit			-				(50,500	)
Borrowings from revolving line of credit			-				22,500
Proceeds from contract sales			2,261				-
Change in restricted cash			161				-
Repayments of capital lease obligations			(3,057	)			(3,881	)
Deferred financing costs			(572	)			(4,749	)
Payments of dividends			-				(60,000	)
Net cash (used in) provided by financing activities			(1,207	)			106,870
Effect of exchange rate changes on cash			458				(19	)
Net (decrease) increase in cash			(224,944	)			122,740
Cash:
Beginning of period			261,905				8,090
End of period		$	36,961			$	130,830
Supplemental non-cash flow disclosure:
Capital lease additions		$	4,746			$	1,629

 

See accompanying notes to unaudited condensed consolidated financial statements

 

  

APX Group Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements (unaudited)

 

NOTE 1—BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES

 

Unaudited Interim Financial Statements

 

The accompanying interim unaudited condensed consolidated financial statements included in this Quarterly Report on Form 10-Q have been prepared by APX Group Holdings, Inc. and subsidiaries (the “Company”) without audit. Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) have been condensed or omitted pursuant to such rules and regulations. The information as of December 31, 2013 included in the unaudited condensed consolidated balance sheets was derived from the Company’s audited consolidated financial statements. The unaudited condensed consolidated financial statements included in this Quarterly Report on Form 10-Q were prepared on the same basis as the audited consolidated financial statements and, in the opinion of management, reflect all adjustments (all of which are considered of normal recurring nature) considered necessary to present fairly the Company’s financial position, results of operations and cash flows for the periods and dates presented. The results of operations for the three and six months ended June 30, 2014 are not necessarily indicative of the results that may be expected for the year ending December 31, 2014.

 

These unaudited condensed consolidated financial statements and notes should be read in conjunction with the Company’s audited consolidated financial statements and related notes for the years ended December 31, 2013 and 2012 set forth in the Company’s Annual Report on Form 10-K dated March 24, 2014, as filed with the Securities and Exchange Commission (“SEC”), which is available on the SEC’s website at sec.gov.

 

The direct-to-home component of the sales cycle for the Company is seasonal in nature. The Company makes investments in the recruitment of the sales force and inventory for the summer sales period prior to each summer season. The sales season generally runs from late April to the end of August each year. The Company experiences increases in subscriber acquisition costs, as well as costs to support the sales force around North America, during this time period.

 

Basis of Presentation –The unaudited condensed consolidated financial statements of the Company are presented for APX Group Holdings, Inc. and its wholly-owned subsidiaries. On April 1, 2013, the Company completed the sale of 2GIG Technologies, Inc. (“2GIG”) and its subsidiary to Nortek, Inc. (the “2GIG Sale”). Therefore, its results of operations are excluded following the sale and the results of operations prior to and subsequent to the 2GIG Sale are not necessarily comparable.

 

Revenue Recognition—The Company recognizes revenue principally on three types of transactions: (i) monitoring, which includes revenues for monitoring and other automation services of the Company’s subscriber contracts and certain subscriber contracts that have been sold, (ii) service and other sales, which includes services provided on contracts, contract fulfillment revenue, sales of products that are not part of the basic equipment package and revenue from 2GIG, and (iii) activation fees on the Company’s contracts, which are amortized over the expected life of the customer.

 

Monitoring services for the Company’s subscriber contracts are billed in advance, generally monthly, pursuant to the terms of subscriber contracts and recognized ratably over the service period. Revenue from monitoring contracts that have been sold is recognized monthly as services are provided based on rates negotiated as part of the contract sales. Costs of providing ongoing monitoring services are expensed in the period incurred.

 

Service and other sales revenue is recognized as services are provided or when title to the products and equipment sold transfers to the customer. Contract fulfillment revenue, included in service and other sales, is recognized when payment is received from customers who cancel their contract in-term. Revenue from sales of products that are not part of the basic equipment package is recognized upon delivery of products.

 

Activation fees are generally charged to a customer when a new account is opened. This revenue is deferred and recognized using a 150% declining balance method over 12 years and converts to a straight-line methodology when the resulting revenue recognition is greater than that from the accelerated method for the remaining estimated life.

 

Through the date of the 2GIG Sale, service and other sales revenue included net recurring services revenue, which was based on back-end services, provided by Alarm.com, for all panels sold to distributors and direct-sell dealers and subsequently placed in service at end-user locations. The Company received a fixed monthly amount from Alarm.com for each system installed with non-Vivint customers that used the Alarm.com platform.

 

  

Revenue from the sale of subscriber contracts is recognized when ownership of the contracts has transferred to the purchaser. Any unamortized deferred revenue and costs related to contract sales are recognized at the time of the sale.

 

Subscriber Contract Costs— A portion of the direct costs of acquiring new subscribers, primarily sales commissions, equipment, and installation costs, are deferred and recognized over a pattern that reflects the estimated life of the subscriber relationships. The Company amortizes these costs using a 150% declining balance method over 12 years and converts to a straight-line methodology when the resulting amortization charge is greater than that from the accelerated method for the remaining estimated life. The Company evaluates subscriber account attrition on a periodic basis, utilizing observed attrition rates for the Company’s subscriber contracts and industry information and, when necessary, makes adjustments to the estimated subscriber relationship period and amortization method.

 

Cash and Cash Equivalents—Cash and cash equivalents consists of highly liquid investments with remaining maturities when purchased of three months or less.

 

Short-term Investments—Other—Short-term investments—other consists of a certificate of deposit with a remaining maturity when purchased of twelve months or less.

 

Restricted Cash and Cash Equivalents—Restricted cash and cash equivalents is restricted for a specific purpose and cannot be included in the general cash account. At June 30, 2014 and December 31, 2013, the restricted cash and cash equivalents was held by a third-party trustee. Restricted cash and cash equivalents consists of highly liquid investments with remaining maturities when purchased of three months or less.

 

Accounts Receivable—Accounts receivable consists primarily of amounts due from customers for recurring monthly monitoring services. The accounts receivable are recorded at invoiced amounts and are non-interest bearing. The gross amount of accounts receivable has been reduced by an allowance for doubtful accounts of $4.5 million and $1.9 million at June 30, 2014 and December 31, 2013, respectively. The Company estimates this allowance based on historical collection rates, subscriber attrition rates, and contractual obligations underlying the sale of the subscriber contracts to third parties. When the Company determines that there are accounts receivable that are uncollectible, they are charged off against the allowance for doubtful accounts. As of June 30, 2014 and December 31, 2013, no accounts receivable were classified as held for sale. Provision for doubtful accounts is included in general and administrative expenses in the accompanying unaudited condensed consolidated statements of operations.

 

The changes in the Company’s allowance for accounts receivable were as follows for the periods ended (in thousands):

  

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2014				2013				2014				2013
Beginning balance		$	1,637			$	1,939			$	1,901			$	2,301
Provision for doubtful accounts			4,760				3,023				7,259				5,439
Write-offs and adjustments			(1,896	)			(2,337	)			(4,659	)			(5,115	)
Balance at end of period		$	4,501			$	2,625			$	4,501			$	2,625

  

Inventories—Inventories, which comprise home automation and security system equipment and parts, are stated at the lower of cost or market with cost determined under the first-in, first-out (FIFO) method. The Company records an allowance for excess and obsolete inventory based on anticipated obsolescence, usage and historical write-offs. The allowance for excess and obsolete inventory was $9.1 million and $3.2 million as of June 30, 2014 and December 31, 2013, respectively.

 

Long-lived Assets and Intangibles—Property and equipment are stated at cost and depreciated on the straight-line method over the estimated useful lives of the assets or the lease term, whichever is shorter. Intangible assets with definite lives are amortized over the remaining estimated economic life of the underlying technology or relationships, which ranges from 2 to 10 years. Amortization expense associated with leased assets is included with depreciation expense. Routine repairs and maintenance are charged to expense as incurred. Definite-lived intangible assets are amortized on the straight-line method over the estimated useful life of the asset or in a pattern in which the economic benefits of the intangible asset are consumed. The Company periodically assesses potential impairment of its long-lived assets and intangibles and performs an impairment review whenever events or changes in circumstances indicate that the carrying value may not be recoverable. In addition, the Company periodically assesses whether events or changes in circumstance continue to support an indefinite life of certain intangible assets or warrant a revision to the estimated useful life of definite-lived intangible assets.

 

  

Deferred Financing Costs—Costs incurred in connection with obtaining debt financing are deferred and amortized utilizing the straight-line method, which approximates the effective-interest method, over the life of the related financing. If such financing is paid off or replaced prior to maturity with debt instruments that have substantially different terms, the unamortized costs are charged to expense. Deferred financing costs included in the accompanying unaudited condensed consolidated balance sheets at June 30, 2014 and December 31, 2013 were $55.0 million and $59.4 million, net of accumulated amortization of $14.9 million and $9.9 million, respectively. Amortization expense on deferred financing costs recognized and included in interest expense in the accompanying unaudited condensed consolidated statements of operations, totaled $2.5 million and $2.1 million for the three months ended June 30, 2014 and 2013, respectively and $5.0 million and $4.2 million for the six months ended June 30, 2014 and 2013, respectively.

 

Residual Income Plan—The Company has a program that allows third-party sales channel partners to receive additional compensation based on the performance of the underlying contracts they create. The Company calculates the present value of the expected future payments and recognizes this amount in the period the commissions are earned. Subsequent accretion and adjustments to the estimated liability are recorded as interest and other expense, respectively. The Company monitors actual payments and customer attrition on a periodic basis and, when necessary, makes adjustments to the liability. The amount included in accrued expenses and other current liabilities was $0.3 million as of both June 30, 2014 and December 31, 2013, and the amount included in other long-term obligations was $2.4 million at both June 30, 2014 and December 31, 2013, representing the present value of the estimated amounts owed to third-party sales channel partners.

 

Stock-Based Compensation—The Company measures compensation cost based on the grant-date fair value of the award and recognizes that cost over the requisite service period of the awards (See Note 12).

 

Income Taxes—The Company accounts for income taxes based on the asset and liability method. Under the asset and liability method, deferred tax assets and deferred tax liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Valuation allowances are established when necessary to reduce deferred tax assets when it is determined that it is more likely than not that some portion of the deferred tax asset will not be realized.

 

The Company recognizes the effect of an uncertain income tax position on the income tax return at the largest amount that is more-likely-than-not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained. The Company’s policy for recording interest and penalties is to record such items as a component of the provision for income taxes.

 

Liability—Contracts Sold—On March 31, 2014, the Company received approximately $2.3 million in proceeds from the sale of certain subscriber contracts to a third-party. Concurrently, the Company entered into an agreement with the buyer to continue providing billing, monitoring and support services for the contracts that were sold for a period of ten years. As a result of this continuing involvement on the part of the Company in the servicing of the contracts, accounting guidance precluded gain recognition at the time of the sale. Accordingly, the Company has treated this transaction as a secured borrowing and recorded a liability for the proceeds received at the time of the sale. The amount included in accrued expenses and other current liabilities related to this liability was $0.3 million and the amount included in contracts sold, net of current portion was $1.8 million as of June 30, 2014. These amounts are being amortized using the effective interest method over twelve years, the expected term of these subscriber contracts.

 

Use of Estimates—The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements. Actual results could differ from those estimates.

 

Concentrations of Credit Risk—Financial instruments that potentially subject the Company to concentration of credit risk consist principally of receivables and cash. At times during the year, the Company maintains cash balances in excess of insured limits. The Company is not dependent on any single customer or geographic location. The loss of a customer would not adversely impact the Company’s operating results or financial position.

 

  

Concentrations of Supply Risk—As of June 30, 2014, approximately 80% of the Company’s installed panels were 2GIG Go!Control panels. On April 1, 2013, the Company completed the 2GIG Sale. In connection with the 2GIG Sale, the Company entered into a five-year supply agreement with 2GIG, pursuant to which they will be the exclusive provider of the Company’s control panel requirements, subject to certain exceptions as provided in the supply agreement. The loss of 2GIG as a supplier could potentially impact the Company’s operating results or financial position.

 

 Fair Value Measurement— Fair value is based on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Assets and liabilities subject to on-going fair value measurement are categorized and disclosed into one of three categories depending on observable or unobservable inputs employed in the measurement. These two types of inputs have created the following fair value hierarchy:

 

Level 1: Quoted prices in active markets that are accessible at the measurement date for assets and liabilities.

 

Level 2: Observable prices that are based on inputs not quoted in active markets, but corroborated by market data.

 

Level 3: Unobservable inputs are used when little or no market data is available.

 

This hierarchy requires the Company to minimize the use of unobservable inputs and to use observable market data, if available, when determining fair value. The Company recognizes transfers between levels of the hierarchy based on the fair values of the respective financial measurements at the end of the reporting period in which the transfer occurred. There were no transfers between levels of the fair value hierarchy during the six months ended June 30, 2014 and the fiscal year 2013.

 

The carrying amounts of the Company’s accounts receivable, accounts payable and accrued and other liabilities approximate their fair values due to their short maturities.

 

Goodwill—The Company conducts a goodwill impairment analysis annually and as necessary if changes in facts and circumstances indicate that the fair value of the Company’s reporting units may be less than its carrying amount. When indicators of impairment do not exist and certain accounting criteria are met, the Company is able to evaluate goodwill impairment using a qualitative approach. When necessary, the Company’s quantitative goodwill impairment test consists of two steps. The first step requires that the Company compare the estimated fair value of its reporting units to the carrying value of the reporting unit’s net assets, including goodwill. If the fair value of the reporting unit is greater than the carrying value of its net assets, goodwill is not considered to be impaired and no further testing is required. If the fair value of the reporting unit is less than the carrying value of its net assets, the Company would be required to complete the second step of the test by analyzing the fair value of its goodwill. If the carrying value of the goodwill exceeds its fair value, an impairment charge is recorded.

 

Foreign Currency Translation and Other Comprehensive Income—The functional currencies of Vivint Canada, Inc. and Vivint New Zealand, Ltd. are the Canadian dollar and the New Zealand dollar, respectively. Accordingly, assets and liabilities are translated from their respective functional currencies into U.S. dollars at period-end rates and revenue and expenses are translated at the weighted-average exchange rates for the period. Adjustments resulting from this translation process are classified as other comprehensive income (loss) and shown as a separate component of equity.

 

Letters of Credit—As of June 30, 2014 and December 31, 2013, the Company had $3.0 million and $2.2 million, respectively, of letters of credit issued in the ordinary course of business, all of which are unused.

 

New Accounting Pronouncement—In May 2014, the FASB issued authoritative guidance which clarifies the principles used to recognize revenue for all entities. The new guidance requires companies to recognize revenue when it transfers goods or services to a customer in an amount that reflects the consideration to which a company expects to be entitled. The guidance is effective for annual and interim periods beginning after December 15, 2016. The guidance allows for either a "full retrospective" adoption or a "modified retrospective" adoption, however early adoption is not permitted. The Company is currently evaluating the impact the adoption of this guidance will have on our consolidated financial statements.

 

In February 2013, the FASB issued authoritative guidance which expands the disclosure requirements for amounts reclassified out of accumulated other comprehensive income (“AOCI”). The guidance requires an entity to provide information about the amounts reclassified out of AOCI by component and present, either on the face of the income statement or in the notes to financial statements, significant amounts reclassified out of AOCI by the respective line items of net income but only if the amount reclassified is required under GAAP to be reclassified to net income in its entirety in the same reporting period. For other amounts, an entity is required to cross-reference to other disclosures required under GAAP that provide additional detail about those amounts. This guidance does not change the current requirements for reporting net income or OCI in financial statements. The guidance became effective for us in the first quarter of fiscal year 2014. The adoption of this guidance did not have a material impact on our financial position, results of operations or cash flows.

 

In July 2013, the FASB issued authoritative guidance which amends the guidance related to the presentation of unrecognized tax benefits and allows for the reduction of a deferred tax asset for a net operating loss carryforward whenever the net operating loss carryforward or tax credit carryforward would be available to reduce the additional taxable income or tax due if the tax position is disallowed. This guidance became effective for us for annual and interim periods beginning in fiscal year 2014. The adoption of this guidance did not have a material impact on our financial position, results of operations or cash flows.

 

  

NOTE 2 – BUSINESS COMBINATIONS

 

Wildfire Acquisition

 

On January 31, 2014, a wholly-owned subsidiary of the Company completed the purchase of certain assets, and assumed certain liabilities, of Wildfire Broadband, LLC (“Wildfire”). Pursuant to the terms of the asset purchase agreement the Company paid aggregate cash consideration of $3.5 million, of which $0.4 million is held in escrow for indemnification obligations and will be released no later than January 31, 2015. This strategic acquisition was made to provide the Company access to Wildfire’s existing customers, wireless internet infrastructure and know-how. The accompanying condensed consolidated financial statements include the financial position and results of operations associated with the Wildfire assets acquired and liabilities assumed from January 31, 2014. The pro forma impact of Wildfire on the Company’s financial position and results of operations for the six months ended June 30, 2014 is immaterial. The associated goodwill is deductible for income tax purposes.

 

The following table summarizes the estimated fair value of the assets acquired and liabilities assumed at the time of acquisition (in thousands):

  

Net assets acquired from Wildfire		$	96
Intangible assets (See Note 9)			2,900
Goodwill			504
Total cash consideration			3,500
Estimated net working capital adjustment			(61	)
Total fair value of the assets acquired and liabilities assumed		$	3,439

 

During the three and six months ended June 30, 2014, the Company incurred costs associated with the Wildfire acquisition, which were not material, consisting of accounting, legal and professional fees and payments to employees directly associated with the acquisition. These costs are included in general and administrative expenses in the accompanying unaudited condensed consolidated statements of operations.

 

NOTE 3 — DIVESTITURE OF SUBSIDIARY

 

On April 1, 2013, the Company completed the 2GIG Sale. Pursuant to the terms of the 2GIG Sale, Nortek, Inc. acquired all of the outstanding common stock of 2GIG for aggregate cash consideration of approximately $148.9 million, including cash, working capital and indebtedness adjustments as provided in the stock purchase agreement. In connection with the 2GIG Sale, the Company entered into a five-year supply agreement with 2GIG, pursuant to which they will be the exclusive provider of the Company’s control panel requirements, subject to certain exceptions as provided in the supply agreement. A portion of the net proceeds from the 2GIG Sale was used to repay $44.0 million of outstanding borrowings under the Company’s revolving credit facility. The terms of the indenture governing the existing senior unsecured notes, the indenture governing the existing senior secured notes and the credit agreement governing the revolving credit facility, permit the Company, subject to certain conditions, to distribute all or a portion of the net proceeds from the 2GIG Sale to the Company’s stockholders. In May 2013, the Company distributed a dividend of $60.0 million from such proceeds to stockholders. Subject to the applicable conditions, the Company may distribute the remaining proceeds in the future. The Company’s financial position and results of operations include 2GIG through March 31, 2013.

 

The following table summarizes the net gain recognized in connection with this divestiture (in thousands):

 

Adjusted net sale price		$	148,378
2GIG assets (including cash of $3,383), net of liabilities			(108,797	)
2.0 technology, net of amortization			16,903
Other			(9,841	)
Net gain on divestiture		$	46,643

 

 

NOTE 4 — VARIABLE INTEREST ENTITY

 

Accounting rules require the primary beneficiary of a variable interest entity (“VIE”) to include the financial position and results of operations of the VIE in its condensed consolidated financial statements. Vivint Solar, Inc. (“Solar”), formed by the Company in April 2011, installs solar panels on the roofs of customers’ homes and enters into agreements for customers to purchase the electricity generated by the panels. Solar also takes advantage of local government and federal incentive programs that offer assistance in generating green power. Solar was consolidated as a VIE by APX Group, Inc. from April 2011 through November 15, 2012. On November 16, 2012, an investor group comprised of certain investment funds affiliated with Blackstone Capital Partners VI L.P., and certain co-investors and management investors (collectively, the “Investors”) purchased Solar for $75.0 million and became its primary beneficiary and, as a result, the Solar financial position and results of operations are not consolidated by the Company subsequent to November 16, 2012. The assets of Solar are restricted in that they are only available to settle the obligations of Solar and not of the Company and similarly, the creditors of Solar have no recourse to the general assets of the Company.

 

The Company and Solar have entered into an agreement under which the Company subleases corporate office space, and provides certain other administrative services, to Solar. During the three months ended June 30, 2014 and 2013, the Company charged $2.5 million and $0.3 million, respectively, and during the six months ended June 30, 2014 and 2013, the Company charged $4.1 million and $0.6 million, respectively, of general and administrative expenses to Solar in connection with this agreement. The balance due from Solar in connection with this agreement and other expenses paid on Solar’s behalf was $2.3 million and $3.1 million at June 30, 2014 and December 31, 2013, respectively, and is included in prepaid expenses and other current assets in the accompanying unaudited condensed consolidated balance sheets.

 

On December 27, 2012, the Company executed a Subordinated Note and Loan Agreement with Solar. The terms of the agreement state that Solar may borrow up to $20.0 million, bearing interest on the outstanding balance at an annual rate of 7.5%, which interest is due and payable semi-annually on June 1 and December 1 of each year commencing on June 1, 2013. The balance outstanding on June 30, 2014, representing principal of $20.0 million and payment-in-kind interest of $2.2 million, and on December 31, 2013, representing principal of $20.0 million and payment-in-kind interest of $1.3 million, is included in long-term investments and other assets, net in the accompanying unaudited condensed consolidated balance sheets. In addition, accrued interest of $0.2 million and $0.1 million on June 30, 2014 and December 31, 2013, respectively, is included in prepaid expenses and other current assets in the accompanying unaudited condensed consolidated balance sheets. These variable interests represent the Company’s maximum exposure to loss from direct involvement with Solar.

 

NOTE 5 – LONG-TERM DEBT

 

On November 16, 2012, APX issued $1.3 billion aggregate principal amount of notes, of which $925.0 million aggregate principal amount of 6.375% senior secured notes due 2019 (the “outstanding 2019 notes”) mature on December 1, 2019 and are secured on a first-priority lien basis by substantially all of the tangible and intangible assets whether now owned or hereafter acquired by the Company, subject to permitted liens and exceptions, and $380.0 million aggregate principal amount of 8.75% senior notes due 2020 (the “outstanding 2020 notes” and together with the outstanding 2019 notes, the “notes”), mature on December 1, 2020.

 

During 2013, the Company completed two offerings of additional 8.75% senior notes due 2020 under the indenture dated November 16, 2012 (the “2020 notes”). On May 31, 2013, the Company issued $200.0 million of 2020 notes at a price of 101.75% and on December 13, 2013, the Company issued an additional $250.0 million of 2020 notes at a price of 101.50%. Blackstone Advisory Partners L.P. participated as one of the initial purchasers of the 2020 notes in each of the May 31, 2013 and December 31, 2013 offerings and received approximately $0.2 million and $0.2 million in fees, respectively, at the time of closing.

 

Interest on the notes accrues at the rate of 6.375% per annum for the outstanding 2019 notes and 8.75% per annum for the outstanding 2020 notes. Interest on the notes is payable semiannually in arrears on each June 1 and December 1. The Company may redeem each series of the notes, in whole or part, at any time at a redemption price equal to the principal amount of the notes to be redeemed, plus a make-whole premium and any accrued and unpaid interest at the redemption date. In addition, APX may redeem the notes at the prices and on the terms specified in the applicable indenture.

 

In connection with each issuance of the notes, the Company entered into Exchange and Registration Rights Agreements (each a “Registration Rights Agreement”) with the initial purchasers of the notes, dated November 16, 2012, May 8, 2013 and December 13, 2013, respectively.

 

  

In connection with the issuance of the initial notes on November 16, 2012 and the subsequent offering on May 31, 2013, in accordance with the applicable Registration Rights Agreements, the Company filed a registration statement on Form S-4 with the Securities and Exchange Commission with respect to an exchange offer to exchange the notes of each series for an issue of Notes (except the Exchange Notes do not contain transfer restrictions). The exchange offer was completed on October 29, 2013.

 

In connection with the issuance of the subsequent offering on December 13, 2013, under the applicable Registration Rights Agreement, the Company filed a registration statement on Form S-4 with the Securities and Exchange Commission with respect to an exchange offer to exchange the Notes of each series for an issue of Notes (except the Exchange Notes do not contain transfer restrictions). This exchange offer was completed on March 7, 2014.

 

Revolving Credit Facility

 

On November 16, 2012, APX, the Company and the other guarantors entered into a revolving credit facility in the aggregate principal amount of $200.0 million. Borrowings bear interest based on the London Interbank Offered Rate (“LIBOR”) or, at the Company’s option, an alternative base rate, plus spread, based upon the Company’s consolidated first lien leverage ratio at the end of each fiscal quarter and a commitment fee of 0.50% on unused portions of the revolving credit facility. The borrowings are due November 16, 2017, which may be repaid at any time without penalty.

 

 

The Company’s outstanding debt at June 30, 2014 had maturity dates of 2019 and beyond and consisted of the following (in thousands):

  

		Outstanding Principal				Unamortized Premium				Net Carrying Amount
Revolving credit facility		$	-			$	-			$	-
6.375% Senior Secured Notes due 2019			925,000				-				925,000
8.75% Senior Notes due 2020			830,000				6,636				836,636
Total Notes payable		$	1,755,000			$	6,636			$	1,761,636

 

The Company’s outstanding debt at December 31, 2013 consisted of the following (in thousands):

 

		Outstanding Principal				Unamortized Premium				Net Carrying Amount
Revolving credit facility		$	-			$	-			$	-
6.375% Senior Secured Notes due 2019			925,000				-				925,000
8.75% Senior Notes due 2020			830,000				7,049				837,049
Total Notes payable		$	1,755,000			$	7,049			$	1,762,049

 

  

NOTE 6 – BALANCE SHEET COMPONENTS

 

The following table presents balance sheet component balances (in thousands):

 

		June 30, 2014				December 31, 2013
Subscriber contract costs
Subscriber contract costs		$	485,696			$	310,666
Accumulated amortization			(45,637	)			(22,350	)
Subscriber contract costs, net		$	440,059			$	288,316
Long-term investments and other assets
Notes receivable from related parties, net of allowance (See Note 4)		$	22,233			$	21,323
Security deposit receivable			6,947				6,261
Other			3,333				92
Total long-term investments and other assets, net		$	32,513			$	27,676
Accrued payroll and commissions
Accrued payroll		$	17,055			$	15,475
Accrued commissions			66,184				30,532
Total accrued payroll and commissions		$	83,239			$	46,007
Accrued expenses and other current liabilities
Accrued interest payable		$	10,972			$	10,982
Loss contingencies			8,463				9,263
Other			13,974				12,873
Total accrued expenses and other current liabilities		$	33,409			$	33,118

  

NOTE 7 – PROPERTY AND EQUIPMENT

 

Property and equipment consisted of the following (in thousands):

 

		June 30, 2014				December 31, 2013				Estimated Useful Lives
Vehicles		$	17,140			$	13,851			3 - 5 years
Computer equipment and software			14,658				6,742			3 - 5 years
Leasehold improvements			11,096				13,345			2 - 15 years
Office furniture, fixtures and equipment			7,316				6,472			7 years
Warehouse equipment			133				123			7 years
Buildings			702				702			39 years
Construction in process			6,174				3,119
			57,219				44,354
Accumulated depreciation and amortization			(12,378	)			(8,536	)
Net property and equipment		$	44,841			$	35,818

  

Property and equipment includes approximately $13.0 million and $13.7 million of assets under capital lease obligations, net of accumulated amortization of $4.2 million and $2.7 million at June 30, 2014 and December 31, 2013, respectively. Depreciation and amortization expense on all property and equipment was $2.7 million and $2.1 million for the three months ended June 30, 2014 and 2013, respectively and $5.2 million and $4.5 million for the six months ended June 30, 2014 and 2013, respectively. Amortization expense relates to assets under capital leases and is included in depreciation and amortization expense.

 

 

NOTE 8 – INTANGIBLE ASSETS

 

The following table presents intangible asset balances (in thousands):

 

		June 30, 2014				December 31, 2013				Estimated Useful Lives
Definite-lived intangible assets:
Customer contracts		$	986,159			$	984,403			10 years
2.0 technology			17,000				17,000			8 years
Smartrove technology			4,040				4,040			3 years
Skypanel technology			3,813				3,814			3 years
Patents			5,964				-			5 years
Non-compete agreements			800				-			3 years
Other intellectual property			650				650			2 years
CMS technology			337				2,300			1 year
			1,018,763				1,012,207
Accumulated amortization			(246,323	)			(171,493	)
Definite-lived intangible assets, net			772,440				840,714
Indefinite-lived intangible assets:
IP addresses			164				-
Domain names			59				-
Total Indefinite-lived intangible assets			223				-
Total intangible assets, net		$	772,663			$	840,714

 

Identifiable intangible assets acquired by the Company in connection with the Wildfire acquisition were $2.1 million of customer contracts and $0.8 million associated with non-compete agreements entered into by certain former members of Wildfire management. In addition, during the six months ended June 30, 2014, the Company acquired $6.2 million of other intangible assets related to patents, domain names and Internet Protocol (“IP”) addresses.

 

On March 29, 2014, the Company implemented new customer relationship management software (“CRM”). Historically, the Company’s customer management system (“CMS”) technology was used for customer support and inventory tracking. The new CRM software replaced the customer support functionality of the CMS technology. Following the CRM implementation, the CMS technology continued to be used for inventory tracking. Due to the implementation of the new CRM software, as of March 31, 2014, the Company determined there to be a significant change in the extent and manner in which the CMS technology was being used. The Company estimated the fair value of the CMS technology as of March 31, 2014 to be $0.3 million based on management experience, inquiry and assessment of the remaining functionality of this technology as it related to inventory tracking. The associated impairment loss of $1.4 million is included in operating expenses in the accompanying unaudited condensed consolidated statement of operations for the six months ended June 30, 2014. In addition, the estimated remaining useful life of the CMS technology was evaluated and revised to one year from March 31, 2014, based on the intended use of the asset. The impact on income from continuing operations and net income from the change in the estimated remaining useful life was immaterial.

 

Amortization expense related to intangible assets was approximately $37.8 million and $40.5 million for the three months ended June 30, 2014 and 2013, respectively. Amortization expense related to intangible assets was approximately $75.3 million and $82.7 million for the six months ended June 30, 2014 and 2013, respectively.

 

  

Estimated future amortization expense of intangible assets, excluding patents currently in process, is as follows as of June 30, 2014 (in thousands):

 

2014 - remaining period		$	75,983
2015			135,222
2016			116,984
2017			100,670
2018			88,961
Thereafter			254,446
Future amortization associated with patents currently in process			174
Total estimated amortization expense		$	772,440

 

NOTE 9 – FAIR VALUE MEASUREMENTS

 

Cash equivalents and restricted cash equivalents are classified as Level 1 as they have readily available market prices in an active market. Short-term investments—other are classified as Level 2 and their cost basis plus accrued interest at June 30, 2014 approximates fair value. The Convertible Note, as defined below, is classified as Level 3 and is valued using its cost basis, which approximates fair value. The following summarizes the financial instruments of the Company at fair value based on the valuation approach applied to each class of security as of June 30, 2014 and December 31, 2013 (in thousands):

 

		Fair Value Measurement at Reporting Date Using
		Balance at June 30, 2014				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
Assets:
Cash equivalents:
Money market funds		$	10,009			$	10,009			$	-			$	-
Short-term investments—other:
Certificate of deposit			60,058				-				60,058				-
Restricted cash equivalents:
Money market funds			14,214				14,214				-				-
Restricted cash equivalents, net of current portion:
Money market funds			14,214				14,214				-				-
Long-term investments and other assets, net
Convertible note			3,000				-				-				3,000
Total assets		$	101,495			$	38,437			$	60,058			$	3,000

 

  

		Fair Value Measurement at Reporting Date Using
		Balance at December 31, 2013				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
Assets:
Cash equivalents:
Money market funds		$	10,002			$	10,002			$	-			$	-
Restricted cash equivalents:
Money market funds			14,214				14,214				-				-
Restricted cash equivalents, net of current portion:
Money market funds			14,214				14,214				-				-
Total assets		$	38,430			$	38,430			$	-			$	-

 

The carrying amounts of the Company’s accounts receivable, accounts payable and accrued and other liabilities approximate their fair values due to their short maturities.

 

On February 19, 2014, the Company invested $3.0 million in a convertible note (“Convertible Note”) of a privately held company (“Investee”) not affiliated with the Company. The Convertible Note has a stated maturity date of February 19, 2015 and bears interest equal to the greater of (a) 0.5% or (b) annual interest rates established for federal income tax purposes by the Internal Revenue Service. The outstanding principal and accrued interest balance of the Convertible Note converts to preferred stock of the Investee no later than August 19, 2014. The Convertible Note has been classified as available-for-sale and measured at fair value in accordance with ASC 320, Investments—Debt and Equity Securities, with remeasurement occurring at the end of each reporting period and any changes in fair value included in other comprehensive income until the Convertible Note converts or matures. As of June 30, 2014, the estimated aggregate fair value of the Convertible Note was equal to its cost of $3.0 million and was considered a Level 3 measurement and is included in long-term investments and other assets, net in the accompanying unaudited condensed consolidated balance sheet as of June 30, 2014.

 

The fair market value of the Company’s Senior Secured Notes was approximately $957.4 million and $941.2 million as of June 30, 2014 and December 31, 2013, respectively. The carrying value of the Company’s Senior Secured Notes was $925.0 million as of June 30, 2014 and December 31, 2013. The Company’s Senior Notes had a fair market value of approximately $848.7 million and $844.5 million as of June 30, 2014 and December 31, 2013, respectively, and a carrying amount of $830.0 million as of both June 30, 2014 and December 31, 2013. The fair value of the Senior Secured Notes and the Senior Notes was considered a Level 2 measurement as the value was determined using observable market inputs, such as current interest rates as well as prices observable from less active markets.

 

In connection with the Wildfire acquisition, the fair value of intangible assets was considered a Level 3 measurement and was determined using the income and market approach. Key assumptions used in the determination of the fair value include estimated earnings and discount rates between 12% and 20%.

 

NOTE 10 – FACILITY FIRE

 

On March 18, 2014, a fire occurred at a facility leased by the company in Lindon, Utah. This facility contained the Company’s primary inventory warehouse and call center operations. Through June 30, 2014, the Company recognized gross expenses of $5.7 million, less probable insurance recoveries of $3.0 million, related to the fire damage. Of the $3.0 million in probable insurance recoveries, $1.8 million were received by the Company prior to June 30, 2014. The expenses associated with the fire primarily related to impairment of damaged assets and recovery costs to maintain business continuity. The Company is seeking additional insurance recoveries and will recognize those when receipt becomes probable. The net expenses of approximately $1.7 million and $2.7 million for the three and six months ended June 30, 2014, respectively, are included in general and administrative costs on the unaudited condensed consolidated statements of operations. The $1.2 million of probable insurance recoveries not yet received from the Company’s insurance provider are included in prepaid expenses and other current assets in the accompanying unaudited condensed consolidated balance sheet at June 30, 2014.

 

 

NOTE 11 – INCOME TAXES

 

In order to determine the quarterly provision (benefit) for income taxes, the Company uses an estimated annual effective tax rate, which is based on expected annual income and statutory tax rates in the various jurisdictions in which the Company operates. Certain significant or unusual items are separately recognized in the quarter during which they occur and can be a source of variability in the effective tax rates from quarter to quarter.

  

The Company’s effective income tax rate for the six months ended June 30, 2014 was approximately (0.84)%. In computing income tax expense (benefit), the Company estimates its annual effective income tax rate jurisdiction by jurisdiction and entity by entity for which tax attributes must be separately considered for the calendar year ending December 31, 2014, excluding discrete items. Each jurisdictional or entity estimated annual tax rate is applied to actual year-to-date pre-tax book income (loss) of each jurisdiction or entity. The Company had no discrete items that affected the calculated income tax benefit or expense for the three and six months ended June 30, 2014. Both the 2014 and 2013 effective tax rates are less than the statutory rate primarily due to the combination of not recognizing benefit for expected pre-tax losses of the US jurisdiction and recognizing current state income tax expense for minimum state taxes.

 

For 2014, the Company expects to realize a loss before income taxes and expects to record a full valuation allowance against the net deferred tax assets of the consolidated group within the US, Canadian and New Zealand jurisdictions. The Company has recorded tax expense for state and local taxes. A valuation allowance is required when there is significant uncertainty as to the ability to realize the deferred tax assets. Because the realization of the deferred tax assets related to the Company’s net operating losses (NOLs) is dependent upon future income related to domestic and foreign jurisdictional operations that have historically generated losses, management determined that the Company continues to not meet the “more likely than not” threshold that those NOLs will be realized. Accordingly, a valuation allowance is required. A similar history of losses is present in the Company’s Canadian and New Zealand jurisdictions. However, as of June 30, 2014, the deferred tax assets related to the Company’s Canadian and New Zealand jurisdictions’ NOLs are offset by existing deferred income tax liabilities resulting in a net deferred tax liability position in both jurisdictions.

 

NOTE 12 – STOCK-BASED COMPENSATION

 

313 Incentive Units

 

The Company’s indirect parent, 313 Acquisition LLC, which is wholly owned by the Investors, has authorized the award of profits interests, representing the right to share a portion of the value appreciation on the initial capital contributions to 313 Acquisition LLC (“Incentive Units”). As of June 30, 2014, a total of 75,181,252 Incentive Units had been awarded to members of senior management and a board member, of which 46,484,562 were issued to the Company’s Chief Executive Officer and President. The Incentive Units are subject to time-based and performance-based vesting conditions, with one-third subject to ratable time-based vesting over a five year period and two-thirds subject to the achievement of certain investment return thresholds by The Blackstone Group, L.P. and its affiliates. The Company anticipates making comparable equity incentive grants at 313 Acquisition LLC to other members of senior management and adopting other equity and cash-based incentive programs for other members of management from time to time. The fair value of stock-based awards is measured at the grant date and is recognized as expense over the employee’s requisite service period. The grant date fair value was determined using a Monte Carlo simulation valuation approach with the following assumptions: expected volatility of 55% to 65%; expected exercise term from 4 to 5 years; and risk-free rate of 0.62% to 1.18%.

 

Vivint Stock Appreciation Rights

 

The Company’s subsidiary, Vivint, has awarded Stock Appreciation Rights (“SARs”) to various levels of key employees. The purpose of the SARs is to attract and retain personnel and provide an opportunity to acquire an equity interest of Vivint. The SARs are subject to time-based and performance-based vesting conditions, with one-third subject to ratable time-based vesting over a five year period and two-thirds subject to the achievement of certain investment return thresholds by The Blackstone Group, L.P. and its affiliates. In connection with this plan, 8,221,250 SARs were outstanding as of June 30, 2014. In addition, 36,065,303 SARs have been set aside for funding incentive compensation pools pursuant to long-term incentive plans established by the Company.

 

The fair value of the Vivint awards is measured at the grant date and is recognized as expense over the employee’s requisite service period. The fair value is determined using a Black-Scholes option valuation model with the following assumptions: expected volatility varies from 55% to 60%, expected dividends of 0%; expected exercise term between 6.01 and 6.50 years; and risk-free rates between 1.72% and 1.77%. Due to the lack of historical exercise data, the Company used the simplified method in determining the estimated exercise term, for all Vivint awards.

 

  

Wireless Stock Appreciation Rights

 

The Company’s subsidiary, Vivint Wireless, has awarded SARs to various key employees. The purpose of the SARs is to attract and retain personnel and provide an opportunity to acquire an equity interest of Vivint Wireless. The SARs are subject to a five year time-based ratable vesting period. In connection with this plan, 70,000 SARs were outstanding as of June 30, 2014. The Company anticipates making similar grants from time to time.

 

 

The fair value of the Vivint Wireless awards is measured at the grant date and is recognized as expense over the employee’s requisite service period. The fair value is determined using a Black-Scholes option valuation model with the following assumptions: expected volatility of 65%, expected dividends of 0%; expected exercise term of 6.50 years; and risk-free rate of 1.51%. Due to the lack of historical exercise data, the Company used the simplified method in determining the estimated exercise term, for all Vivint Wireless awards.

 

Stock-based compensation expense in connection with stock awards is presented by entity as follows (in thousands):

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2014				2013				2014				2013
Operating expenses		$	21			$	-			$	30			$	-
Selling expenses			36				-				104				-
General and administrative expenses			401				445				769				673
Total stock-based compensation		$	458			$	445			$	903			$	673

 

NOTE 13 – COMMITMENTS AND CONTINGENCIES

 

Indemnification – Subject to certain limitations, the Company is obligated to indemnify its current and former directors, officers and employees with respect to certain litigation matters and investigations that arise in connection with their service to the Company. These obligations arise under the terms of its certificate of incorporation, its bylaws, applicable contracts, and Delaware and California law. The obligation to indemnify generally means that the Company is required to pay or reimburse the individuals’ reasonable legal expenses and possibly damages and other liabilities incurred in connection with these matters.

 

Legal – The Company is named from time to time as a party to lawsuits. Actions filed against the Company include commercial, intellectual property, customer, and labor and employment related claims, including complaints of alleged wrongful termination and potential class action lawsuits regarding alleged violations of federal and state wage and hour and other laws. In general, litigation can be expensive and disruptive to normal business operations. Moreover, the results of legal proceedings are difficult to predict, and the costs incurred in litigation can be substantial. The Company believes the amounts provided in its financial statements are adequate in light of the probable and estimated liabilities. Factors that the Company considers in the determination of the likelihood of a loss and the estimate of the range of that loss in respect of legal matters include the merits of a particular matter, the nature of the litigation, the length of time the matter has been pending, the procedural posture of the matter, whether the Company intends to defend the matter, the likelihood of settling for an insignificant amount and the likelihood of the plaintiff accepting an amount in this range. Because such matters are subject to many uncertainties, the ultimate outcomes are not predictable and there can be no assurances that the actual amounts required to satisfy alleged liabilities from the matters described above will not exceed the amounts reflected in the Company’s financial statements or that the matters will not have a material adverse effect on the Company’s results of operations, financial condition or cash flows.

 

The Company is party to claims, legal actions and complaints arising in the ordinary course of business related to its sales, marketing, the provision of its services and equipment claims. The Company regularly reviews outstanding legal claims and actions to determine if reserves for expected negative outcomes of such claims and actions are necessary. The Company had reserves for all such matters of approximately $8.5 million and $9.3 million as of June 30, 2014 and December 31, 2013, respectively. In conjunction with one of the settlements, the Company is obligated to pay certain future royalties, based on sales of future products.

 

Operating Leases – The Company leases office, warehouse space, certain equipment, software and an aircraft under operating leases with related and unrelated parties expiring in various years through 2028. The leases require the Company to pay additional rent for increases in operating expenses and real estate taxes and contain renewal options. The Company entered into a lease agreement for its corporate headquarters in 2009. In July 2012, the Company entered into a lease for additional office space for an initial lease term of 15 years.

 

  

Total rent expense for operating leases was approximately $2.9 million and $1.3 million for the three months ended June 30, 2014 and 2013, respectively, and $4.4 million and $2.7 million for the six months ended June 30, 2014 and 2013, respectively.

 

Capital Leases – The Company also leases certain equipment under capital leases with expiration dates through August 2016. On an ongoing basis, the Company enters into vehicle lease agreements under a Fleet Lease Agreement. The lease agreements are typically 36 month leases for each vehicle and the average remaining life for the fleet is 26 months as of June 30, 2014. As of June 30, 2014 and December 31, 2013, the capital lease obligation balance was $12.2 million and $10.5 million, respectively.

 

NOTE 14 – RELATED PARTY TRANSACTIONS

 

Long-term investments and other assets, includes amounts due for non-interest bearing advances made to employees that are expected to be repaid in excess of one year. Amounts due from related parties as of both June 30, 2014 and December 31, 2013, amounted to approximately $0.3 million. As of June 30, 2014 and December 31, 2013, this amount was fully reserved.

 

Prepaid expenses and other current assets at June 30, 2014 and December 31, 2013 included a receivable for $0.1 million and $0.3 million, respectively, from certain members of management in regards to their personal use of the corporate jet.

 

The Company incurred additional expenses of $0.4 million and $0.2 million during the three months ended June 30, 2014 and 2013, respectively, and $1.2 million and $0.3 million during the six months ended June 30, 2014 and 2013, respectively, for other related-party transactions including contributions to the charitable organization Vivint Gives Back, legal fees, and services. Accrued expenses and other current liabilities at June 30, 2014 and December 31, 2013, included a payable to Vivint Gives Back for $0.2 million and $1.1 million, respectively. In addition, transactions with Solar, as described in Note 4, are considered to be related party transactions.

 

On November 16, 2012, the Company entered into a support and services agreement with Blackstone Management Partners L.L.C. (“BMP”), an affiliate of Blackstone. Under the support and services agreement, the Company engaged BMP to provide monitoring, advisory and consulting services on an ongoing basis. In consideration for these services, the Company agreed to pay an annual monitoring fee equal to the greater of (i) a minimum base fee of $2.7 million subject to adjustments if the Company engages in a business combination or disposition that is deemed significant and (ii) the amount of the monitoring fee paid in respect of the immediately preceding fiscal year, without regard to any post-fiscal year “true-up” adjustments as determined by the agreement. The Company incurred expenses of approximately $1.0 million and $0.7 million during the three months ended June 30, 2014 and 2013, respectively, and approximately $1.7 million and $1.6 million during the six months ended June 30, 2014 and 2013, respectively.

 

Under the support and services agreement, the Company also engaged BMP to arrange for Blackstone’s portfolio operations group to provide support services customarily provided by Blackstone’s portfolio operations group to Blackstone’s private equity portfolio companies of a type and amount determined by such portfolio services group to be warranted and appropriate. BMP will invoice the Company for such services based on the time spent by the relevant personnel providing such services during the applicable period but in no event shall the Surviving Company be obligated to pay more than $1.5 million during any calendar year.

 

Transactions involving related parties cannot be presumed to be carried out at an arm’s-length basis.

 

NOTE 15 – SEGMENT REPORTING

 

Prior to the 2GIG Sale on April 1, 2013, the Company conducted business through two operating segments, Vivint and 2GIG. These segments were managed and evaluated separately by management due to the differences in their products and services. The primary source of revenue for the Vivint segment is generated through monitoring services provided to subscribers, in accordance with their subscriber contracts. The primary source of revenue for the 2GIG segment was through the sale of electronic security and automation systems to security dealers and distributors, including Vivint. Fees and expenses charged by 2GIG to Vivint, related to intercompany purchases, were eliminated in consolidation.

 

For the three months ended June 30, 2014 and 2013 and the six months ended June 30, 2014, the Company conducted business through one operating segment, Vivint. The following table presents a summary of revenue, costs and expenses for the six months ended June 30, 2013 and assets as of June 30, 2013 (in thousands):

 

 

			Vivint				2GIG				Eliminations				Consolidated Total
Revenues		$	221,187			$	60,220			$	(42,713	)		$	238,694
All other costs and expenses			251,129				52,200				(32,914	)			270,415
(Loss) income from operations		$	(29,942	)		$	8,020			$	(9,799	)		$	(31,721	)
Intangible assets, including goodwill		$	1,754,104			$	-			$	-			$	1,754,104
Total assets		$	2,260,977			$	-			$	-			$	2,260,977

 

NOTE 16 – EMPLOYEE BENEFIT PLANS

 

Beginning March 1, 2010, Vivint and 2GIG offered eligible employees the opportunity to defer a percentage of their earned income into company-sponsored 401(k) plans. 2GIG made matching contributions to the plan in the amount of $36,000 for the six months ended June 30, 2013. No matching contributions were made to the plans for the three or six months ended June 30, 2014 or the three months ended June 30, 2013.

 

NOTE 17 – GUARANTOR AND NON-GUARANTOR SUPPLEMENTAL FINANCIAL INFORMATION

 

The Senior Secured Notes due 2019 and the Senior Notes due 2020 were issued by APX. The Senior Secured Notes due 2019 and the Senior Notes due 2020 are fully and unconditionally guaranteed, jointly and severally by APX Group Holdings, Inc. (“Parent Guarantor”) and each of APX’s existing and future material wholly-owned U.S. restricted subsidiaries. APX’s existing and future foreign subsidiaries are not expected to guarantee the Notes.

 

Presented below is the condensed consolidating financial information of APX, subsidiaries of APX that are guarantors (the “Guarantor Subsidiaries”), and APX’s subsidiaries that are not guarantors (the “Non-Guarantor Subsidiaries”) as of June 30, 2014 and December 31, 2013 and for the three and six months ended June 30, 2014 and 2013. The unaudited condensed consolidating financial information reflects the investments of Holdings in the Guarantor Subsidiaries and the Non-Guarantor Subsidiaries using the equity method of accounting.

 

Supplemental Condensed Consolidating Balance Sheet

June 30, 2014

(In thousands)

(unaudited)

 

		Parent				APX Group, Inc.				Guarantor Subsidiaries				Non-Guarantor Subsidiaries				Eliminations				Consolidated
Assets
Current assets		$	-			$	70,084			$	171,666			$	24,598			$	(37,667	)		$	228,681
Property and equipment, net			-				-				44,149				692				-				44,841
Subscriber acquisition costs, net			-				-				398,635				41,424				-				440,059
Deferred financing costs, net			-				54,952				-				-				-				54,952
Investment in subsidiaries			377,700				2,025,166				-				-				(2,402,866	)			-
Intercompany receivable			-				-				55,627				-				(55,627	)			-
Intangible assets, net			-				-				703,245				69,418				-				772,663
Goodwill			-				-				804,545				32,157				-				836,702
Restricted cash			-				-				14,214				-				-				14,214
Long-term investments and other assets			-				-				32,494				19				-				32,513
Total Assets		$	377,700			$	2,150,202			$	2,224,575			$	168,308			$	(2,496,160	)		$	2,424,625
Liabilities and Stockholders’ Equity
Current liabilities		$	-			$	10,972			$	213,513			$	47,681			$	(37,667	)		$	234,499
Intercompany payable			-				-				-				55,627				(55,627	)			-
Notes payable and revolving line of credit, net of current portion			-				1,761,636				-				-				-				1,761,636
Liability-contracts sold, net of current portion			-				-				1,824				-				-				1,824
Capital lease obligations, net of current portion			-				-				7,857				12				-				7,869
Deferred revenue, net of current portion			-				-				23,634				2,650				-				26,284
Other long-term obligations			-				-				5,313				365				-				5,678
Deferred income tax liability			-				(106	)			242				8,999				-				9,135
Total equity			377,700				377,700				1,972,192				52,974				(2,402,866	)			377,700
Total liabilities and stockholders’ equity		$	377,700			$	2,150,202			$	2,224,575			$	168,308			$	(2,496,160	)		$	2,424,625

 

 

Supplemental Condensed Consolidating Balance Sheet

December 31, 2013

(In thousands)

(unaudited)

 

		Parent				APX Group, Inc.				Guarantor Subsidiaries				Non-Guarantor Subsidiaries				Eliminations				Consolidated
Assets
Current assets		$	-			$	249,209			$	89,768			$	7,163			$	(24,137	)		$	322,003
Property and equipment, net			-				-				35,218				600				-				35,818
Subscriber acquisition costs, net			-				-				262,064				26,252				-				288,316
Deferred financing costs, net			-				59,375				-				-				-				59,375
Investment in subsidiaries			490,243				1,953,465				-				-				(2,443,708	)			-
Intercompany receivable			-				-				44,658				-				(44,658	)			-
Intangible assets, net			-				-				764,296				76,418				-				840,714
Goodwill			-				-				804,041				32,277				-				836,318
Restricted cash			-				-				14,214				-				-				14,214
Long-term investments and other assets			-				(302	)			27,954				24				-				27,676
Total Assets		$	490,243			$	2,261,747			$	2,042,213			$	142,734			$	(2,512,503	)		$	2,424,434
Liabilities and Stockholders’ Equity
Current liabilities		$	-			$	9,561			$	117,544			$	31,254			$	(24,137	)		$	134,222
Intercompany payable			-				-				-				44,658				(44,658	)			-
Notes payable and revolving line of credit, net of current portion			-				1,762,049				-				-				-				1,762,049
Capital lease obligations, net of current portion			-				-				6,268				-				-				6,268
Deferred revenue, net of current portion			-				-				16,676				1,857				-				18,533
Other long-term obligations			-				-				3,559				346				-				3,905
Deferred income tax liability			-				(106	)			289				9,031				-				9,214
Total equity			490,243				490,243				1,897,877				55,588				(2,443,708	)			490,243
Total liabilities and stockholders’ equity		$	490,243			$	2,261,747			$	2,042,213			$	142,734			$	(2,512,503	)		$	2,424,434

 

 

Condensed Consolidating Statements of Operations and Comprehensive (Loss) Income

For the Three Months Ended June 30, 2014

(In thousands)

(unaudited)

 

		Parent				APX Group, Inc.				Guarantor Subsidiaries				Non-Guarantor Subsidiaries				Eliminations				Consolidated
Revenues		$	-			$	-			$	127,146			$	7,852			$	(799	)		$	134,199
Costs and expenses			-				-				155,369				10,075				(799	)			164,645
Loss from operations			-				-				(28,223	)			(2,223	)			-				(30,446	)
Loss from subsidiaries			(66,271	)			(30,932	)			-				-				97,203				-
Other (expense) income, net			-				(35,305	)			149				68				-				(35,088	)
Loss before income tax expenses			(66,271	)			(66,237	)			(28,074	)			(2,155	)			97,203				(65,534	)
Income tax expense			-				34				14				689				-				737
Net loss		$	(66,271	)		$	(66,271	)		$	(28,088	)		$	(2,844	)		$	97,203			$	(66,271	)
Other comprehensive loss, net of tax effects:
Net loss		$	(66,271	)		$	(66,271	)		$	(28,088	)		$	(2,844	)		$	97,203			$	(66,271	)
Foreign currency translation adjustment			-				4,676				2,769				1,908				(4,676	)			4,677
Total other comprehensive income			-				4,676				2,769				1,908				(4,676	)			4,677
Comprehensive loss		$	(66,271	)		$	(61,595	)		$	(25,319	)		$	(936	)		$	92,527			$	(61,594	)

 

Condensed Consolidating Statements of Operations and Comprehensive Loss

For the Three Months Ended June 30, 2013

(In thousands)

(unaudited)

 

		Parent				APX Group, Inc.				Guarantor Subsidiaries				Non-Guarantor Subsidiaries				Eliminations				Consolidated
Revenues		$	-			$	-			$	107,797			$	7,216			$	(761	)		$	114,252
Costs and expenses			-				-				131,100				7,642				(761	)			137,981
Loss from operations			-				-				(23,303	)			(426	)			-				(23,729	)
Loss from subsidiaries			(21,527	)			(41,002	)			-				-				62,529				-
Other expense, net			60,000				19,475				233				(17	)			(60,000	)			19,691
Income (loss) before income tax expenses			38,473				(21,527	)			(23,070	)			(443	)			2,529				(4,038	)
Income tax expense (benefit)			-				-				17,569				(80	)			-				17,489
Net income (loss)		$	38,473			$	(21,527	)		$	(40,639	)		$	(363	)		$	2,529			$	(21,527	)
Other comprehensive income (loss), net of tax effects:
Net income (loss)		$	38,473			$	(21,527	)		$	(40,639	)		$	(363	)		$	2,529			$	(21,527	)
Foreign currency translation adjustment			-				(4,368	)			(2,367	)			(2,001	)			4,368				(4,368	)
Total other comprehensive loss			-				(4,368	)			(2,367	)			(2,001	)			4,368				(4,368	)
Comprehensive income (loss)		$	38,473			$	(25,895	)		$	(43,006	)		$	(2,364	)		$	6,897			$	(25,895	)

 

  

Condensed Consolidating Statements of Operations and Comprehensive (Loss) Income

For the Six Months Ended June 30, 2014

(In thousands)

(unaudited)

 

		Parent				APX Group, Inc.				Guarantor Subsidiaries				Non-Guarantor Subsidiaries				Eliminations				Consolidated
Revenues		$	-			$	-			$	249,488			$	16,458			$	(1,593	)		$	264,353
Costs and expenses			-				-				290,679				17,942				(1,593	)			307,028
Loss from operations			-				-				(41,191	)			(1,484	)			-				(42,675	)
Loss from subsidiaries			(113,551	)			(42,945	)			-				-				156,496				-
Other (expense) income, net			-				(70,572	)			659				(18	)			-				(69,931	)
Loss before income tax expenses			(113,551	)			(113,517	)			(40,532	)			(1,502	)			156,496				(112,606	)
Income tax expense			-				34				40				871				-				945
Net loss		$	(113,551	)		$	(113,551	)		$	(40,572	)		$	(2,373	)		$	156,496			$	(113,551	)
Other comprehensive (loss) income, net of tax effects:
Net loss		$	(113,551	)		$	(113,551	)		$	(40,572	)		$	(2,373	)		$	156,496			$	(113,551	)
Foreign currency translation adjustment			-				105				345				(240	)			(105	)			105
Total other comprehensive income (loss) loss			-				105				345				(240	)			(105	)			105
Comprehensive loss		$	(113,551	)		$	(113,446	)		$	(40,227	)		$	(2,613	)		$	156,391			$	(113,446	)

 

Condensed Consolidating Statements of Operations and Comprehensive Loss

For the Six Months Ended June 30, 2013

(In thousands)

(unaudited)

 

		Parent				APX Group, Inc.				Guarantor Subsidiaries				Non-Guarantor Subsidiaries				Eliminations				Consolidated
Revenues		$	-			$	-			$	227,328			$	12,885			$	(1,519	)		$	238,694
Costs and expenses			-				-				257,203				14,731				(1,519	)			270,415
Loss from operations			-				-				(29,875	)			(1,846	)			-				(31,721	)
Loss from subsidiaries			(52,436	)			(46,230	)			-				-				98,666				-
Other expense, net			60,000				(6,206	)			(23	)			(23	)			(60,000	)			(6,252	)
Income (loss) before income tax expenses			7,564				(52,436	)			(29,898	)			(1,869	)			38,666				(37,973	)
Income tax expense (benefit)			-				-				14,933				(470	)			-				14,463
Net income (loss )		$	7,564			$	(52,436	)		$	(44,831	)		$	(1,399	)		$	38,666			$	(52,436	)
Other comprehensive income (loss), net of tax effects:
Net income (loss)		$	7,564			$	(52,436	)		$	(44,831	)		$	(1,399	)		$	38,666			$	(52,436	)
Foreign currency translation adjustment			-				(6,987	)			(3,722	)			(3,265	)			6,987				(6,987	)
Total other comprehensive loss			-				(6,987	)			(3,722	)			(3,265	)			6,987				(6,987	)
Comprehensive income (loss)		$	7,564			$	(59,423	)		$	(48,553	)		$	(4,664	)		$	45,653			$	(59,423	)

 

 

Supplemental Condensed Consolidating Statements of Cash Flows

For the Six Months Ended June 30, 2014

(In thousands)

(unaudited)

 

		Parent				APX Group, Inc.				Guarantor Subsidiaries				Non-Guarantor Subsidiaries				Eliminations				Consolidated
Cash flows from operating activities:
Net cash (used in) provided by operating activities		$	-			$	(413	)		$	14,750			$	20,754			$	-			$	35,091
Cash flows from investing activities:
Subscriber contract costs			-				-				(157,770	)			(16,797	)			-				(174,567	)
Capital expenditures			-				-				(11,869	)			(188	)			-				(12,057	)
Investment in subsidiary			-				(177,897	)			-				-				177,897				-
Acquisition of intangible assets			-				-				(6,127	)			-				-				(6,127	)
Net cash used in acquisition			-				-				(3,500	)			-				-				(3,500	)
Investment in marketable securities			-				(60,000	)			-				-				-				(60,000	)
Investment in convertible note			-				-				(3,000	)			-				-				(3,000	)
Other assets			-				-				(40	)			5								(35	)
Net cash used in investing activities			-				(237,897	)			(182,306	)			(16,980	)			177,897				(259,286	)
Cash flows from financing activities:
Proceeds from issuance of notes			-				-				-				-				-				-
Intercompany receivable			-				-				(10,969	)			-				10,969				-
Intercompany payable			-				-				177,897				10,969				(188,866	)			-
Proceeds from contract sales			-				-				2,261				-				-				2,261
Change in restricted cash			-				-				161				-				-				161
Repayments of capital lease obligations			-				-				(3,056	)			(1	)			-				(3,057	)
Deferred financing costs			-				(572	)			-				-				-				(572	)
Net cash (used in) provided by financing activities			-				(572	)			166,294				10,968				(177,897	)			(1,207	)
Effect of exchange rate changes on cash			-				-				-				458				-				458
Net (decrease) increase in cash			-				(238,882	)			(1,262	)			15,200				-				(224,944	)
Cash:
Beginning of period			-				248,908				8,291				4,706				-				261,905
End of period		$	-			$	10,026			$	7,029			$	19,906			$	-			$	36,961

 

 

Supplemental Condensed Consolidating Statements of Cash Flows

For the Six Months Ended June 30, 2013

(In thousands)

(unaudited)

  

		Parent				APX Group, Inc.				Guarantor Subsidiaries				Non-Guarantor Subsidiaries				Eliminations				Consolidated
Cash flows from operating activities:
Net cash provided by (used in) operating activities		$	60,000			$	(38	)		$	22,606			$	20,505			$	(60,000	)		$	43,073
Cash flows from investing activities:
Subscriber contract costs			-				-				(142,134	)			(14,608	)			-				(156,742	)
Capital expenditures			-				-				(3,756	)			(25	)			-				(3,781	)
Proceeds from the sale of subsidiary			-				143,262				-				-				-				143,262
Investment in subsidiary			-				(136,649	)			-				-				136,649				-
Proceeds from the sale of capital assets			-				-				9				-				-				9
Net cash used in acquisition			-				-				(4,272	)			-				-				(4,272	)
Other assets			-				-				(5,660	)			-				-				(5,660	)
Net cash provided by (used in) investing activities			-				6,613				(155,813	)			(14,633	)			136,649				(27,184	)
Cash flows from financing activities:
Proceeds from note payable			-				203,500				-				-				-				203,500
Intercompany receivable			-				-				(2,522	)			-				2,522				-
Intercompany payable			-				-				136,649				2,522				(139,171	)			-
Repayments of revolving line of credit			-				(50,500	)			-				-				-				(50,500	)
Borrowings from revolving line of credit			-				22,500				-				-				-				22,500
Repayments of capital lease obligations			-				-				(3,881	)			-				-				(3,881	)
Deferred financing costs							(4,749	)			-				-				-				(4,749	)
Payment of dividends			(60,000	)			(60,000	)			-				-				60,000				(60,000	)
Net cash (used in) provided by financing activities			(60,000	)			110,751				130,246				2,522				(76,649	)			106,870
Effect of exchange rate changes on cash			-				-				-				(19	)			-				(19	)
Net increase in cash			-				117,326				(2,961	)			8,375				-				122,740
Cash:
Beginning of period			-				399				4,188				3503				-				8,090
End of period		$	-			$	117,725			$	1,227			$	11,878			$	-			$	130,830

 

 

 

NOTE 18 – SUBSEQUENT EVENT

 

On July 1, 2014, APX Group, Inc. issued an additional $100.0 million of 2020 notes. In connection with the issuance, Blackstone Advisory Partners L.P. participated as one of the initial purchasers of the 2020 notes and received approximately $0.1 million in fees at the time of closing.

 

In connection with the issuance of the notes, the Company entered into an Exchange and Registration Rights Agreement, dated July 1, 2014, with the original purchasers of the notes.

 

  

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Introduction

 

The following discussion and analysis provides information which management believes is relevant to an assessment and understanding of our consolidated results of operations and financial condition. The discussion should be read in conjunction with the consolidated financial statements and notes thereto contained in the Annual Report on Form 10-K for the year ended December 31, 2013. This discussion contains forward-looking statements and involves numerous risks and uncertainties, including, but not limited to, those described in the “Risk Factors” section of this Quarterly Report. Actual results may differ materially from those contained in any forward-looking statements. Unless the context otherwise requires, references to “we”, “us”, “our”, and “the Company” are intended to mean the business and operations of APX Group Holdings, Inc. and its consolidated subsidiaries.

 

Non-GAAP Financial Measures

 

This Quarterly Report on Form 10-Q includes Adjusted EBITDA, which is a supplemental measure that is not required by, or presented in accordance with, accounting principles generally accepted in the United States (“GAAP”). It is not a measurement of our financial performance under GAAP and should not be considered as an alternative to net income or any other measure derived in accordance with GAAP or as an alternative to cash flows from operating activities as a measure of our liquidity. We define “Adjusted EBITDA” as net income (loss) before interest expense (net of interest income), income and franchise taxes, and depreciation and amortization (including amortization of capitalized subscriber acquisition costs), further adjusted to exclude the effects of certain contract sales to third parties, non-capitalized subscriber acquisition costs, stock based compensation and certain unusual, non-cash, non-recurring and other items permitted in certain covenant calculations under the indentures governing our existing senior secured notes and our existing senior unsecured notes and the credit agreement governing our revolving credit facility. We caution investors that amounts presented in accordance with our definition of Adjusted EBITDA may not be comparable to similar measures disclosed by other issuers, because not all issuers and analysts calculate Adjusted EBITDA in the same manner. We believe that Adjusted EBITDA provides useful information about flexibility under our covenants to investors, lenders, financial analysts and rating agencies since these groups have historically used EBITDA-related measures in our industry, along with other measures, to estimate the value of a company, to make informed investment decisions, and to evaluate a company’s ability to meet its debt service requirements. Adjusted EBITDA eliminates the effect of non-cash depreciation of tangible assets and amortization of intangible assets, much of which results from acquisitions accounted for under the purchase method of accounting. Adjusted EBITDA also eliminates the effects of interest rates and changes in capitalization which management believes may not necessarily be indicative of a company’s underlying operating performance. Adjusted EBITDA is also used by us to measure covenant compliance under the indentures governing our existing senior secured notes and our existing senior unsecured notes and the credit agreement governing our revolving credit facility.

 

See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Financial Resources” for a reconciliation of Adjusted EBITDA to net loss, as we believe net loss is the most comparable financial measure calculated in accordance with GAAP. Adjusted EBITDA should be considered in addition to and not as a substitute for, or superior to, financial measures presented in accordance with GAAP.

 

Business Overview

 

We are one of the largest residential security solutions companies and one of the largest and fastest-growing home automation services providers in North America. In February 2013, we were recognized by Forbes magazine as one of America’s Most Promising Companies. Our fully integrated and remotely accessible residential services platform offers subscribers a suite of products and services that includes interactive security, life-safety, energy management and home automation. We utilize a scalable direct-to-home sales model to originate a majority of our new subscribers, which allows us control over our net subscriber acquisition costs. We have built a high-quality subscriber portfolio, with an average credit score of 717, as of June 30, 2014, through our underwriting criteria and compensation structure. Unlike many of our competitors, who generally focus on either subscriber origination or servicing, we originate, install, service and monitor our entire subscriber base, which allows us to control the overall subscriber experience. We seek to deliver a quality subscriber experience with a combination of innovative development of new products and services and a commitment to customer service, which together with our focus on originating high-quality new subscribers, has enabled us to achieve attrition rates that we believe are historically at or below industry averages. Utilizing this model, we have built a portfolio of approximately 851,000 subscribers, as of June 30, 2014. Approximately 96% and 95% of our revenues during the three months ended June 30, 2014 and 2013, respectively, and 96% and 88% during the six months ended June 30, 2014 and 2013, respectively, consisted of contractually committed recurring revenues, which have historically resulted in consistent and predictable operating results.

 

 

Recent Transactions

 

On April 1, 2013, we completed the sale of 2GIG Technologies, Inc. and its subsidiary (“2GIG”) to Nortek, Inc. (the “2GIG Sale”). Pursuant to the terms of the 2GIG Sale, Nortek acquired all of the outstanding common stock of 2GIG for aggregate cash consideration of approximately $148.9 million. In connection with the 2GIG Sale, we retained sole ownership of the intellectual property and exclusive rights with respect to the next generation of our control panels and certain peripheral equipment. We expect this proprietary equipment will be a critical component of our future service offerings. In addition, we entered into a five-year supply agreement with 2GIG, pursuant to which they will be the exclusive provider of our control panel requirements, subject to certain exceptions as provided in the supply agreement. A portion of the net proceeds from the 2GIG Sale were used to temporarily repay $44.0 million of outstanding borrowings under our revolving credit facility. The terms of the indentures governing the notes and the credit agreement governing our revolving credit facility permit us, subject to certain conditions, to distribute all or a portion of the net proceeds from the 2GIG Sale to our stockholders. In May 2013, we distributed $60.0 million of such proceeds to our stockholders. Subject to the applicable conditions, we may distribute the remaining proceeds in the future. Our results of operations include the results of 2GIG through the date of the 2GIG Sale.

 

In May and December 2013, we issued and sold an additional $200.0 million and $250.0 million, respectively, aggregate principal amount of 8.75% senior notes due 2020. On July 1, 2014, we issued and sold an additional $100.0 million aggregate principal amount of 8.75% senior notes due 2020.

 

Basis of Presentation

 

The unaudited condensed consolidated financial statements for the three and six months ended June 30, 2014 and 2013, respectively, present the financial position and results of operations of APX Group Holdings, Inc. and its wholly-owned subsidiaries. We have historically conducted business through our Vivint and 2GIG operating segments. On April 1, 2013, we completed the sale of 2GIG to Nortek. See “—Recent Transactions.” Therefore, 2GIG is excluded from our operating results, beginning on the date of the 2GIG Sale. The results of our 2GIG operating segment include the results of 2GIG Technologies, Inc., which was our consolidated subsidiary until its sale to Nortek.

 

Historically, a substantial majority of 2GIG’s revenues were generated from Vivint through (i) sales of its security systems; and (ii) fees billed to Vivint associated with a third-party monitoring platform. Sales to Vivint represented approximately 71% of 2GIG’s revenues on a stand-alone basis from January 1, 2013 through the date of the 2GIG Sale. The results of 2GIG’s operations discussed in this Quarterly Report on Form 10-Q exclude intercompany activity with Vivint, as these transactions were eliminated in consolidation.

 

The term “attrition” as used in this quarterly report on Form 10-Q refers to the aggregate number of cancelled subscribers during a period divided by the monthly weighted average number of total subscribers for such period. Subscribers are considered cancelled when they terminate in accordance with the terms of their contract, are terminated by us or if payment from such subscribers is deemed uncollectible (120 days past due). Sales of contracts to third parties and certain subscriber residential moves are excluded from the attrition calculation. The term “net subscriber acquisition costs” as used in this quarterly report on Form 10-Q refers to the gross costs to generate and install a subscriber net of any fees collected at the time of the contract signing. The term “RMR” is the recurring monthly revenue billed to a subscriber. The term “total RMR” is the aggregate RMR billed to all subscribers. The term “total subscribers” is the aggregate number of our active subscribers at the end of a given period. The term “average RMR per subscriber” is the total RMR divided by the total subscribers. This is also commonly referred to as Average Revenue per User, or “ARPU.” The term “average RMR per new subscriber” is the aggregate RMR for new subscribers originated during a period divided by the number of new subscribers originated during such period.

 

Key Factors Affecting Operating Results

 

Our business is driven through the generation of new subscribers and servicing and maintaining our existing subscriber base. The generation of new subscribers requires significant upfront investment, which in turn provides predictable contractual recurring monthly revenue generated from our monitoring and additional services. We market our service offerings through two sales channels, direct-to-home and inside sales. Historically, most of our new subscriber accounts were generated through direct-to-home sales, primarily from April through August. New subscribers generated through inside sales was approximately 21% of total new subscriber additions in the twelve months ended June 30, 2014, as compared to 23% of total new subscribers in the twelve months ended June 30, 2013. Although new subscribers generated through inside sales decreased as a percentage of our total new subscriber additions during the twelve months ended June 30, 2014 compared to the same period ended June 30, 2013, over time we expect the number of subscribers originated through inside sales to increase, resulting from increased advertising and expansion of our direct-sales calling centers.

 

 

Our operating results are impacted by the following key factors: number of subscriber additions, net subscriber acquisition costs, average RMR per subscriber, subscriber adoption rate of additional services beyond our Advanced Home Security package, subscriber attrition, the costs to monitor and service our subscribers, the level of general and administrative expenses and the availability and cost of capital required to generate new subscribers. We focus our investment decisions on generating new subscribers and servicing our existing subscribers in the most cost-effective manner, while maintaining a high level of customer service to minimize subscriber attrition. These decisions are based on the projected cash flows and associated margins generated over the expected life of the subscriber relationship. Attrition is defined as the aggregate number of cancelled subscribers during a period divided by the monthly weighted average number of total subscribers for such period. Subscribers are considered cancelled when they terminate in accordance with the terms of their contract, are terminated by us, or if payment from such subscribers is deemed uncollectible (120 days past due). Sales of contracts to third parties and certain subscriber moves are excluded from the attrition calculation.

 

Our ability to increase subscribers depends on a number of factors, both external and internal. External factors include the overall macroeconomic environment and competition from other companies in the geographies we serve, particularly in those markets where our direct-to-home sales representatives are present. Some of our current competitors have longer operating histories, greater name recognition and substantially greater financial and marketing resources than us. In the future, other companies may also choose to begin offering services similar to ours. In addition, because such a large percentage of our new subscribers are generated through direct-to-home sales, any actions limiting this sales channel could negatively affect our ability to grow our subscriber base. We are continually evaluating ways to improve the effectiveness of our subscriber acquisition activities in both our direct-to-home and inside sales channels. For example, during 2014 we introduced alternative awareness and demand generation strategies using broad media sources in a limited number of markets throughout the U.S. in an effort to reach additional consumers and increase sales leads.

 

Internal factors include our ability to recruit, train and retain personnel, along with the level of investment in sales and marketing efforts. We believe maintaining competitive compensation structures, differentiated product offerings and establishing a strong brand are critical to attracting and retaining high-quality personnel and competing effectively in the markets we serve. As a result, we expect to increase our investment in advertising in the markets we serve, in an effort to generate greater awareness of the Vivint brand. Successfully growing our revenue per subscriber depends on our ability to continue expanding our technology platform by offering additional value added services demanded by the market. Therefore, we continually evaluate the viability of additional service packages that could further leverage our existing technology platform and sales channels. As evidence of this focus on new services, since 2010, we have successfully expanded our service packages from residential security into energy management, security plus and home automation, which allows us to charge higher RMR for these additional service packages. During 2013, we began offering high-speed wireless internet to a limited number of residential customers and in 2014, we began offering identity protection services. These service offerings leverage our existing direct-to-home selling model for the generation of new subscribers. During the six months ended June 30, 2014, approximately 68% of our new subscribers contracted for one of our additional service packages. Due to the high rate of adoption for these additional service packages, our average RMR per new subscriber has increased from $44.50 in 2009 to $61.60 for the six months ended June 30, 2014, an increase of 38%.

 

We focus on managing the costs associated with monitoring and service without jeopardizing our award-winning service quality. We believe our ability to retain subscribers over the long-term starts with our underwriting criteria and is enhanced by maintaining our consistent quality service levels.

 

Subscriber attrition has a direct impact on the number of subscribers who we monitor and service and on our financial results, including revenues, operating income and cash flows. A portion of the subscriber base can be expected to cancel its service every year. Subscribers may choose not to renew or may terminate their contracts for a variety of reasons, including relocation, cost, switching to a competitor’s service or service issues. If a subscriber relocates but continues their service, we do not consider this as a cancellation. If a subscriber discontinues their service and transfers the original subscriber’s contract to a new subscriber continuing the revenue stream, we also do not consider this as a cancellation. We analyze our attrition by tracking the number of subscribers who cancel as a percentage of the average number of subscribers at the end of each twelve month period. We caution investors that not all companies, investors and analysts in our industry define attrition in the same manner.

 

 

The table below presents subscriber data for Vivint for the twelve months ended June 30, 2014 and year the ended December 31, 2013:

 

		Twelve Months Ended June 30, 2014				Year Ended December 31, 2013
Beginning balance of subscribers			754,304				671,818
Net new additions			208,447				219,034
Subscriber contracts sold			(2,185	)			-
Attrition			(109,437	)			(95,352	)
Ending balance of subscribers			851,129				795,500
Monthly average subscribers			799,989				743,544
Attrition rate			13.7	%			12.8	%

 

Historically, we have experienced an increased level of subscriber cancellations in the months surrounding the expiration of such subscribers’ initial contract term. Attrition in any twelve month period may be impacted by the number of subscriber contracts reaching the end of their initial term in such period. Increases in attrition in the twelve months ended June 30, 2014, reflect the effect of the 2008 60-month and the 2010 42-month pools reaching the end of their initial contract terms. We believe this trend in cancellation at the end of the initial contract term is comparable to other companies within our industry.

 

How We Generate Revenue

 

Vivint

 

Our primary source of revenue is generated through monitoring services provided to our subscribers in accordance with their subscriber contracts. The remainder of our revenue is generated through additional services, activation fees, upgrades and maintenance and repair fees. Monitoring revenues accounted for 96% and 95% of total revenues for the three months ended June 30, 2014 and 2013, respectively, and 96% and 95% for the six months ended June 30, 2014 and 2013, respectively.

 

Monitoring revenue. Monitoring services for our subscriber contracts are billed in advance, generally monthly, pursuant to the terms of subscriber contracts and recognized ratably over the service period. The amount of RMR billed is dependent upon which of our service packages the subscriber contracts for. We generally realize higher RMR for our Home Automation, Energy Management and Security Plus service packages than our Home Security service package. Historically, we have generally offered contracts to subscribers that range in length from 36 to 60 months that are subject to automatic annual or monthly renewal after the expiration of the initial term. At the end of each monthly period, the portion of monitoring fees related to services not yet provided are deferred and recognized as these services are provided.

 

Service and other sales revenue. Our service and other sales revenue is primarily comprised of amounts charged for selling additional equipment, and maintenance and repair. These amounts are billed, and the associated revenue recognized, at the time of installation or when the services are performed. Service and other sales revenue also includes contract fulfillment revenue, which relates to amounts paid by subscribers who cancel their monitoring contract in-term and for which we have no future service obligation to them. We recognize this revenue upon receipt of payment from the subscriber.

 

Activation fees. Activation fees represent upfront one-time charges billed to subscribers at the time of installation. The revenue associated with these fees is deferred and recognized using a 150% declining balance method over 12 years and converts to a straight-line methodology when the resulting revenue recognition is greater than that from the accelerated method for the remaining estimated life.

 

2GIG

 

2GIG’s primary source of revenue was generated through the sale of electronic home security and automation products to dealers and distributors throughout North America. The remainder of the revenue was earned from monthly recurring service fees. System sales, which are included in service and other sales revenue on our consolidated statements of operations, accounted for approximately 14% of total consolidated revenues from January 1, 2013 through the date of the 2GIG Sale. Product sales accounted for approximately 92% of 2GIG’s total revenues on a stand-alone basis from January 1, 2013 through the date of the 2GIG Sale.

 

 

Service and other sales revenue. Net sales revenue from distribution of the 2GIG products was recognized when title to the products transferred to the customer, which occurred upon shipment from our third-party logistics provider’s facility to the customer. Invoicing occurred at the time of shipment and in certain cases, included freight costs based on specific vendor contracts.

 

Recurring services revenue. Net recurring services revenue was based on back-end services for all panels sold to distributors and direct-sell dealers and subsequently placed in service in end-user locations. The back-end services are provided by Alarm.com, an independent platform services provider. 2GIG received a fixed monthly amount from Alarm.com for each of our systems installed with customers that used the Alarm.com platform.

 

Costs and Expenses

 

Vivint

 

Operating expenses. Operating expenses primarily consists of labor associated with monitoring and servicing subscribers and labor and equipment expenses related to field service. In addition, a portion of general and administrative expenses, comprised of certain human resources, facilities and information technologies costs are allocated to operating expenses. This allocation is primarily based on employee headcount and facility square footage occupied. Because our field service technicians perform most subscriber installations generated through our inside sales channels, the costs incurred by the field service associated with these installations are allocated to capitalized subscriber acquisition costs.

 

Selling expenses. Selling expenses are primarily comprised of costs associated with housing for our direct-to-home sales representatives, advertising and lead generation, marketing and recruiting, certain portions of sales commissions, overhead (including allocation of certain general and administrative expenses) and other costs not directly tied to a specific subscriber origination. These costs are expensed as incurred.

 

General and administrative expenses. General and administrative expenses consist largely of finance, legal, research and development, human resources, information technology and executive management expenses, including stock-based compensation expense. Stock-based compensation expense is recorded within various components of our costs and expenses. General and administrative expenses also include the provision for doubtful accounts. We allocate approximately one-third of our gross general and administrative expenses, excluding the provision for doubtful accounts, into operating and selling expenses in order to reflect the overall costs of those components of the business. In addition, in connection with a sublease agreement, we sublease corporate office space and provide certain other administrative services to Vivint Solar, Inc. (“Solar”) and charge Solar the costs associated with this sublease agreement (See Note 4).

 

Depreciation and amortization. Depreciation and amortization consists of depreciation from property and equipment, amortization of equipment leased under capital leases, capitalized subscriber acquisition costs and intangible assets.

 

2GIG

 

Operating expenses. 2GIG did not directly manufacture, assemble, warehouse or ship any of the products it sold. Its products were produced by contract manufacturers, and warehoused and fulfilled through third-party logistics providers. Operating expenses primarily consisted of cost of goods sold, freight charges, royalty fees on licensed technology, warehouse expenses, and fulfillment service fees charged by its logistics providers.

 

General and administrative expenses. General and administrative expenses consisted largely of finance, research and development (“R&D”), including third-party engineering costs, legal, operations, sales commissions, and executive management costs. 2GIG’s personnel-related costs were included in general and administrative expense.

 

Depreciation and amortization. Depreciation and amortization consisted of depreciation of property and equipment.

 

Key Operating Metrics

 

In evaluating our results, we review the key performance measures discussed below. We believe that the presentation of key performance measures is useful to investors and lenders because they are used to measure the value of companies such as ours with recurring revenue streams.

 

Total Subscribers

 

Total subscribers is the aggregate number of our active subscribers at the end of a given period.

 

 

Total Recurring Monthly Revenue

 

Total RMR is the aggregate RMR billed to all subscribers. This revenue is earned for Home Automation, Energy Management, Security Plus and Home Security service offerings.

 

Average RMR per Subscriber

 

Average RMR per subscriber is the total RMR divided by the total subscribers. This is also commonly referred to as Average Revenue per User, or ARPU.

 

  

Results of operations

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2014				2013				2014				2013
		(in thousands)
Revenue
Vivint		$	134,199			$	114,252			$	264,353			$	221,187
2GIG			-				-				-				17,507
Total revenue			134,199				114,252				264,353				238,694
Costs and expenses
Vivint			164,645				137,981				307,028				251,129
2GIG			-				-				-				19,286
Total costs and expenses			164,645				137,981				307,028				270,415
Loss from continuing operations
Vivint			(30,446	)			(23,729	)			(42,675	)			(29,942	)
2GIG			-				-				-				(1,779	)
Total loss from continuing operations			(30,446	)			(23,729	)			(42,675	)			(31,721	)
Other expenses (income)			35,088				(19,691	)			69,931				6,252
Loss before taxes			(65,534	)			(4,038	)			(112,606	)			(37,973	)
Income tax expense			737				17,489				945				14,463
Net loss		$	(66,271	)		$	(21,527	)		$	(113,551	)		$	(52,436	)
Key operating metrics (1)
Total Subscribers, as of June 30 (thousands)			851.1				754.3
Total RMR (thousands) (end of period)		$	45,826			$	39,314
Average RMR per Subscriber		$	53.84			$	52.12

 

(1)

Reflects Vivint metrics only, excluding the wireless internet business, as of the end of the periods presented

 

Three Months Ended June 30, 2014 Compared to the Three Months Ended June 30, 2013 – Vivint

 

Revenues

 

The following table provides the significant components of our revenue for the three month period ended June 30, 2014 and the three month period ended June 30, 2013:

 

		Three Months Ended June 30,
		2014				2013				% Change
Monitoring revenue		$	128,602			$	108,646				18	%
Service and other sales revenue			4,719				5,322				(11	)
Activation fees			878				284				NM
Total revenues		$	134,199			$	114,252				17	%

 

Total revenues increased $20.0 million, or 17%, for the three months ended June 30, 2014 as compared to the three months ended June 30, 2013, primarily due to the growth in monitoring revenue, which increased $20.0 million, or 18%. This increase resulted from $16.4 million of fees from the net addition of approximately 97,000 subscribers at June 30, 2014 compared to June 30, 2013 and a $5.3 million increase from continued growth in the percentage of our subscribers contracting for new products and service packages, partially offset by a $1.8 million increase in refunds and credits during the period.

 

  

Service and other sales revenue decreased $0.6 million, or 11%, for the three months ended June 30, 2014 as compared to the three months ended June 30, 2013. This decrease was primarily due to a decrease in upgrade revenue of $1.2 million related to subscriber service upgrades and purchases of additional equipment, offset in part by an increase in other revenue of $0.7 million.

 

The revenue associated with activation fees is deferred upon billing and recognized over the estimated life of the subscriber relationship. There was deemed to be no fair value associated with deferred activation fee revenues at the time of our acquisition by an investor group led by affiliates of our sponsor, The Blackstone Group L.P. (the “Sponsor”) on November 16, 2012 (the “Acquisition”). Thus, revenues recognized related to activation fees increased $0.6 million, or 209%, for the three months ended June 30, 2014 as compared to the three months ended June 30, 2013, primarily due to the increase in the number of subscribers from whom we have collected activation fees since the date of the Acquisition.

 

Costs and Expenses

 

		Three Months Ended June 30,
		2014				2013				% Change
Operating expenses		$	47,216			$	38,435				23	%
Selling expenses			28,739				28,298				2
General and administrative			35,326				24,910				42
Depreciation and amortization			53,364				46,338				15
Total costs and expenses		$	164,645			$	137,981				19	%

 

Operating expenses increased $8.9 million, or 23%, for the three months ended June 30, 2014 as compared to the three months ended June 30, 2013, primarily to support the growth in our subscriber base. This increase was principally comprised of $6.3 million in personnel costs within our monitoring, customer support and field service functions and a $2.9 million increase in cellular communications fees related to our monitoring services.

  

Selling expenses, excluding amortization of capitalized subscriber acquisition costs, increased $0.4 million, or 2%, for the three months ended June 30, 2014 as compared to the three months ended June 30, 2013, primarily due to a $2.4 million increase in facility, administrative and information technology costs, offset by a $0.6 million decrease in advertising costs and a $1.7 million decrease in personnel costs.

 

General and administrative expenses increased $10.4 million, or 42%, for the three months ended June 30, 2014 as compared to the three months ended June 30, 2013, partly due to a $2.9 million increase in personnel costs, primarily related to information technologies, research and development and management staffing to support the expected growth of the business and our wireless internet initiative. The increase was also due to a $1.8 million increase in the provision for doubtful accounts, primarily related to the growth in our accounts receivable, a $1.5 million increase in advertising costs, a $1.0 million increase in information technology costs, $0.9 million increase in other third-party contracted services, and a $0.4 million increase in facility costs, all to support the growth in our business. In addition, in connection with the facility fire described in Note 10 of the accompanying condensed consolidated financial statements, we incurred an estimated $1.0 million of fire related losses, net of probable insurance recoveries.

 

Depreciation and amortization increased $7.0 million, or 15%, for the three months ended June 30, 2014 as compared to the three months ended June 30, 2013. The increase was primarily due to increased amortization of subscriber contract costs.

 

  

Other Expenses, net

 

		Three Months Ended June 30,
		2014				2013				% Change
Interest expense		$	35,712			$	27,381				30	%
Interest income			(572	)			(396	)			44
Other income, net			(52	)			(33	)			58
Gain on 2GIG Sale			-				(46,643	)			(100	)
Total other expenses, net		$	35,088			$	(19,691	)			(278	)%

 

Interest expense increased $8.3 million, or 30%, for the three months ended June, 2014, as compared with the three months ended June, 2013, due to a higher principal balance on our debt. During the three months ended June 30, 2013, we realized a gain of $46.6 million as a result of the 2GIG Sale. See Note 3 of our unaudited Condensed Consolidated Financial Statements for additional information.

  

Income Taxes

 

		Three Months Ended June 30,
		2014				2013				% Change
Income tax expense		$	737			$	17,489				(96	)%

 

Income tax expense decreased $16.8 million, or 96%, for the three months ended June 30, 2014 as compared with the three months ended June 30, 2013. After the 2GIG Sale on April 1, 2013, we were in a net deferred tax asset position, which required the application of a full valuation allowance against this deferred tax asset, resulting in income tax expense for the three months ended June 30, 2013. Our tax expense during the three months ended June 30, 2014 was primarily due to an increase in tax expense associated with our Canadian operations.

 

Six Months Ended June 30, 2014 Compared to the Six Months Ended June 30, 2013 – Vivint

 

Revenues

 

The following table provides the significant components of our revenue for the six month period ended June 30, 2014 and the six month period ended June 30, 2013:

 

		Six Months Ended June 30,
		2014				2013				% Change
Monitoring revenue		$	253,156			$	210,566				20	%
Service and other sales revenue			9,553				10,257				(7	)
Activation fees			1,644				364				352
Total revenues		$	264,353			$	221,187				20	%

 

Total revenues increased $43.2 million, or 20%, for the six months ended June 30, 2014 as compared to the six months ended June 30, 2013, primarily due to the growth in monitoring revenue, which increased $42.6 million, or 20%. This increase resulted from $34.7 million of fees from the net addition of approximately 97,000 subscribers at June 30, 2014 compared to June 30, 2013 and a $10.7 million increase from continued growth in the percentage of our subscribers contracting for new products and service packages, partially offset by a $2.9 million increase in refunds and credits during the period.

 

  

Service and other sales revenue decreased $0.7 million, or 7%, for the six months ended June 30, 2014 as compared to the six months ended June 30, 2013. This decrease was primarily due to a decrease in upgrade revenue related to subscriber service upgrades and purchases of additional equipment.

 

The revenue associated with activation fees is deferred upon billing and recognized over the estimated life of the subscriber relationship. There was deemed to be no fair value associated with deferred activation fee revenues at the time of the Acquisition. Thus, revenues recognized related to activation fees increased $1.3 million, or 352%, for the six months ended June 30, 2014 as compared to the six months ended June 30, 2013, primarily due to the increase in the number of subscribers from whom we have collected activation fees since the date of the Acquisition.

 

Costs and Expenses

 

		Six Months Ended June 30,
		2014				2013				% Change
Operating expenses		$	88,533			$	72,461				22	%
Selling expenses			54,318				48,906				11
General and administrative			60,461				39,768				52
Depreciation and amortization			103,716				89,994				15
Total costs and expenses		$	307,028			$	251,129				22	%

 

Operating expenses increased $16.1 million, or 22%, for the six months ended June 30, 2014 as compared to the six months ended June 30, 2013, primarily to support the growth in our subscriber base. This increase was principally comprised of $10.5 million in personnel costs within our monitoring, customer support and field service functions and a $3.8 million increase in cellular communications fees related to our monitoring services. In addition, we recognized a loss on impairment of $1.4 million associated with our CMS technology (See Note 8 to our accompanying unaudited condensed consolidated financial statements).

 

Selling expenses, excluding amortization of capitalized subscriber acquisition costs, increased $5.4 million, or 11%, for the six months ended June 30, 2014 as compared to the six months ended June 30, 2013, primarily due to a $4.4 million increase in facility, administrative and information technology costs and a $0.9 million increase in advertising costs, all to support the expected increase in our subscriber contract originations.

 

General and administrative expenses increased $20.7 million, or 52%, for the six months ended June 30, 2014 as compared to the six months ended June 30, 2013, partly due to a $11.6 million increase in personnel costs, primarily related to information technologies, research and development and management staffing to support the expected growth of the business and our wireless internet initiative. The increase was also due to a $1.9 million increase in the provision for doubtful accounts, primarily related to the growth in our accounts receivable, a $1.6 million increase in advertising costs, a $0.9 million increase in facility costs, a $0.7 million increase in insurance premiums and property taxes, and a $0.5 million increase in other third-party contracted services, all to support the growth in our business. In addition, in connection with the facility fire described in Note 10 of the accompanying condensed consolidated financial statements, we incurred an estimated $2.6 million of fire related losses, net of probable insurance recoveries.

 

Depreciation and amortization increased $13.7 million, or 15%, for the six months ended June 30, 2014 as compared to the six months ended June 30, 2013. The increase was primarily due to increased amortization of subscriber contract costs.

 

  

Six Months Ended June 30, 2014 Compared to the Six Months Ended June 30, 2013 – 2GIG

 

All intercompany revenue and expenses between Vivint and 2GIG have been eliminated in consolidation and from the amounts presented below.

 

		Six Months Ended June 30,
		2014				2013				% Change
Total revenue		$	-			$	17,507				NM
Operating expenses			-				11,667				NM
General and administrative			-				5,481				NM
Other expenses			-				2,138				NM
Loss from operations		$	-			$	(1,779	)			NM

 

2GIG is no longer included in our results of operations, from the date of the 2GIG Sale.

 

Six Months Ended June 30, 2014 Compared to the Six Months Ended June 30, 2013 – Consolidated

 

Other Expenses, net

  

		Six Months Ended June 30,
		2014				2013				% Change
Interest expense		$	71,352			$	53,254				34	%
Interest income			(1,124	)			(676	)			66
Other (income) expenses, net			(297	)			317				(194	)
Gain on 2GIG Sale			-				(46,643	)			(100	)
Total other expenses, net		$	69,931			$	6,252				1,019	%

 

Interest expense increased $18.1 million, or 34%, for the six months ended June 30, 2014, as compared with the six months ended June 30, 2013, due to a higher principal balance on our debt. Other income for the six months ended June 30, 2014 was $0.3 million, primarily attributable to gains on the sale and disposal of assets. Other expense of $0.3 million for the six months ended June 30, 2013, was primarily due to losses on the sale and disposal of assets. During the six months ended June 30, 2013, we realized a gain of $46.6 million as a result of the 2GIG Sale. See Note 3 of our unaudited Condensed Consolidated Financial Statements for additional information.

 

Income Taxes

 

		Six Months Ended June 30,
		2014				2013				% Change
Income tax expense		$	945			$	14,463				(93	)%

 

Income tax expense decreased $13.5 million, or 93%, for the six months ended June 30, 2014 as compared with the six months ended June 30, 2013. After the 2GIG Sale on April 1, 2013, we were in a net deferred tax asset position, which required the application of a full valuation allowance against this deferred tax asset, resulting in income tax expense for the six months ended June 30, 2013. Our tax expense during the six months ended June 30, 2014 was primarily due to an increase in tax expense associated with our Canadian operations.

 

  

Liquidity and Capital Resources

 

Our primary source of liquidity has historically been cash from operations, proceeds from the issuance of debt securities and borrowing availability under our revolving credit facility. As of June 30, 2014, we had $37.0 million of cash, $60.1 million of short-term investments maturing in July 2014 and $197.0 million of availability under our revolving credit facility (after giving effect to $3.0 million of letters of credit outstanding). On July 1, 2014, we issued and sold an additional $100.0 million of 8.75% senior notes due 2020.

 

Cash Flow and Liquidity Analysis

 

Significant factors influencing our liquidity position include cash flows generated from monitoring and other fees received from the subscribers we service and the level of investment in capitalized subscriber acquisition costs. Our cash flows provided by operating activities include cash received from RMR, along with upfront activation fees, upgrade and other maintenance and repair fees. Cash used in operating activities includes the cash costs to monitor and service those subscribers, and certain costs, principally marketing and the portion of subscriber acquisition costs that are expensed and general and administrative costs. We have historically generated, and expect to continue generating, positive cash flows from operating activities. Historically, we financed subscriber acquisition costs through our operating cash flows, the issuance of debt, and to a lesser extent, through the issuance of equity and contract sales to third parties.

 

The direct-to-home sales are seasonal in nature. We make investments in the recruitment of our direct-to-home sales force and the inventory for the April through August sales period prior to each sales season. We experience increases in subscriber acquisition costs, as well as costs to support the sales force throughout North America, during this time period.

 

The following table provides a summary of cash flow data (dollars in thousands):

 

		Six Months Ended June 30,
		2014				2013				% Change
Net cash provided by operating activities		$	35,091			$	43,073				(19	)%
Net cash used in investing activities			(259,286	)			(27,184	)			854
Net cash (used in) provided by financing activities			(1,207	)			106,870				(101	)

 

Cash Flows from Operating Activities

 

We generally reinvest the cash flows from operating activities into our business, primarily to maintain and grow our subscriber base and to expand our infrastructure to support this growth and enhance our existing, and develop new, service offerings. These investments are focused on generating new subscribers, increasing the revenue from our existing subscriber base, enhancing the overall quality of service provided to our subscribers, increasing the productivity and efficiency of our workforce and back-office functions necessary to scale our business.

 

For the six months ended June 30, 2014, net cash provided by operating activities was $35.1 million. This cash was primarily generated from a net loss of $113.6 million, adjusted for $109.2 million in non-cash amortization, depreciation and stock-based compensation, a $37.6 million increase in accrued expenses and other liabilities, primarily related to an increase in accrued payroll and commissions, and a $57.8 million increase in accounts payable, primarily related to purchases of inventory. This was partially offset by a $52.2 million increase in inventories due to the seasonality of our inventory purchases and usage related to our direct-to-home sales channel.

 

For the six months ended June 30, 2013, net cash provided by operating activities was $43.1 million. This cash was primarily generated from a net loss of $52.4 million, adjusted for $97.0 million in non-cash amortization, depreciation and stock-based compensation expenses, a $45.0 million increase in accrued expenses and other liabilities and a $16.3 million increase in fees paid by subscribers in advance of when the associated revenue is recognized. This was partially offset by a $25.9 million increase in inventories due to the seasonality of our inventory purchases and usage.

 

 

Cash Flows from Investing Activities

 

Historically, our investing activities have primarily consisted of capitalized subscriber acquisition costs, capital expenditures, business combinations and technology acquisitions. Capital expenditures primarily consist of periodic additions to property and equipment to support the growth in our business.

 

For the six months ended June 30, 2014 and 2013, net cash used in investing activities was $259.3 million and $27.2 million, respectively. For the six months ended June 30, 2014, our cash used in investing activities primarily consisted of capitalized subscriber acquisition costs of $174.6 million, investments in certificates of deposit of $60.0 million, capital expenditures of $12.1 million, and the acquisition of certain patents and other intangible assets of $6.1 million. For the six months ended June 30, 2013, cash used in investing activities primarily consisted of $156.7 million of capitalized subscriber acquisition costs, partially offset by $143.3 million of proceeds from the 2GIG Sale.

 

Cash Flows from Financing Activities

 

Historically, our cash flows from financing activities were primarily to fund the portion of upfront costs associated with generating new subscribers that are not covered through our operating cash flows.

 

For the six months ended June 30, 2014, net cash used in financing activities was $1.2 million, consisting primarily of $3.1 million of repayments under our capital lease obligations, partially offset by $2.3 million of proceeds from contract sales. For the six months ended June 30, 2013, our net cash provided by financing activities was from the issuance of $203.5 million of senior unsecured notes payable, $22.5 million of borrowings from our revolving line of credit, partially offset by $60.0 million of payments of dividends and $50.5 million of repayments of our revolving line of credit.

 

Long-Term Debt

 

We are a highly leveraged company with significant debt service requirements. As of June 30, 2014, we had approximately $1.8 billion of total debt outstanding, consisting of $925.0 million of 6.375% senior secured notes due 2019 (the “outstanding 2019 notes”), $830.0 million of 8.75% senior notes due 2020 (the “outstanding 2020 notes”) and no borrowings under the revolving credit facility. On July 1, 2014, we issued and sold an additional $100.0 million of 8.75% senior notes due 2020.

 

Revolving Credit Facility

 

On November 16, 2012, we entered into a $200.0 million senior secured revolving credit facility, with a five year maturity, of which $197.0 million was undrawn and available as of June 30, 2014 (after giving effect to $3.0 million of outstanding letters of credit). In addition, we may request one or more term loan facilities, increased commitments under the revolving credit facility or new revolving credit commitments, in an aggregate amount not to exceed $225.0 million. Availability of such incremental facilities and/or increased or new commitments will be subject to certain customary conditions.

 

On June 28, 2013, we amended and restated the credit agreement to provide for a new repriced tranche of revolving credit commitments with a lower interest rate. Nearly all of the existing tranches of revolving credit commitments was terminated and converted into the repriced tranche, with the unterminated portion of the existing tranche continuing to accrue interest at the original higher rate.

 

Borrowings under the revolving credit facility bear interest at a rate per annum equal to an applicable margin plus, at our option, either (1) the base rate determined by reference to the highest of (a) the Federal Funds rate plus 0.50%, (b) the prime rate of Bank of America, N.A. and (c) the LIBOR rate determined by reference to the costs of funds for U.S. dollar deposits for an interest period of one month, plus 1.00% or (2) the LIBOR rate determined by reference to the London interbank offered rate for dollars for the interest period relevant to such borrowing. The applicable margin for base rate-based borrowings (1)(a) under the repriced tranche is currently 2.0% per annum and (b) under the former tranche is currently 3.0% and (2)(a) the applicable margin for LIBOR rate-based borrowings (a) under the repriced tranche is currently 3.0% per annum and (b) under the former tranche is currently 4.0%. The applicable margin for borrowings under the revolving credit facility is subject to one step-down of 25 basis points based on our consolidated first lien net leverage ratio at the end of each fiscal quarter, commencing with delivery of our consolidated financial statements for the first full fiscal quarter ending after the closing date.

 

In addition to paying interest on outstanding principal under the revolving credit facility, we are required to pay a quarterly commitment fee (which will be subject to one step-down based on our consolidated first lien net leverage ratio) to the lenders under the revolving credit facility in respect of the unutilized commitments thereunder. We also pay customary letter of credit and agency fees.

 

 

2019 Notes

 

On November 16, 2012, we issued $925.0 million of the 2019 notes. Interest on the 2019 notes is payable semi-annually in arrears on each June 1 and December 1, commencing June 1, 2013.

 

We may, at our option, redeem at any time and from time to time prior to December 1, 2015, some or all of the 2019 notes at 100% of their principal amount thereof plus accrued and unpaid interest to the redemption date plus a “make-whole premium.” Prior to December 1, 2015, during any 12 month period, we also may, at our option, redeem at any time and from time to time up to 10% of the aggregate principal amount of the issued 2019 notes at a price equal to 103% of the principal amount thereof, plus accrued and unpaid interest. From and after December 1, 2015, we may, at our option, redeem at any time and from time to time some or all of the 2019 notes at 104.781%, declining ratably on each anniversary thereafter to par from and after December 1, 2018, in each case, plus any accrued and unpaid interest to the date of redemption. In addition, on or prior to December 1, 2015, we may, at our option, redeem up to 35% of the aggregate principal amount of the 2019 notes with the proceeds from certain equity offerings at 106.37%, plus accrued and unpaid interest to the date of redemption.

 

2020 Notes

 

On November 16, 2012, we issued $380.0 million of outstanding 2020 notes. Interest on the outstanding 2020 notes is payable semi-annually in arrears on each June 1 and December 1, commencing June 1, 2013. During the year ended December 31, 2013, we issued an additional $450.0 million of outstanding 2020 notes under the indenture dated as of November 16, 2012. In July 2014, we issued an additional $100.0 million of 8.75% senior notes due 2020.

 

We may, at our option, redeem at any time and from time to time prior to December 1, 2015, some or all of the 2020 notes at 100% of their principal amount thereof plus accrued and unpaid interest to the redemption date plus a “make-whole premium.” From and after December 1, 2015, we may, at our option, redeem at any time and from time to time some or all of the 2020 notes at 106.563%, declining ratably on each anniversary thereafter to par from and after December 1, 2018, in each case, plus any accrued and unpaid interest to the date of redemption. In addition, on or prior to December 1, 2015, we may, at our option, redeem up to 35% of the aggregate principal amount of the 2020 notes with the proceeds from certain equity offerings at 108.75%, plus accrued and unpaid interest to the date of redemption.

 

Guarantees and Security

 

All of our obligations under the revolving credit facility, the 2019 notes and the 2020 notes are guaranteed by APX Group Holdings, Inc. (“Parent Guarantor”) and each of our existing and future material wholly-owned U.S. restricted subsidiaries to the extent such entities guarantee indebtedness under the revolving credit facility or our other indebtedness. See Note 16 of our unaudited condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q for additional financial information regarding guarantors and non-guarantors.

 

The obligations under the revolving credit facility and the 2019 notes are secured by a security interest in (i) substantially all of the present and future tangible and intangible assets of APX Group, Inc., exclusive of its subsidiaries (the “Issuer”), and the guarantors, including without limitation equipment, subscriber contracts and communication paths, intellectual property, fee-owned real property, general intangibles, investment property, material intercompany notes and proceeds of the foregoing, subject to permitted liens and other customary exceptions, (ii) substantially all personal property of the Issuer and the guarantors consisting of accounts receivable arising from the sale of inventory and other goods and services (including related contracts and contract rights, inventory, cash, deposit accounts, other bank accounts and securities accounts), inventory and intangible assets to the extent attached to the foregoing books and records of the Issuer and the guarantors, and the proceeds thereof, subject to permitted liens and other customary exceptions, in each case held by the Issuer and the guarantors and (iii) a pledge of all of the Capital Stock of the Issuer, each of its subsidiary guarantors and each restricted subsidiary of the Issuer and its subsidiary guarantors, in each case other than excluded assets and subject to the limitations and exclusions provided in the applicable collateral documents.

 

Under the terms of the applicable security documents and intercreditor agreement, the proceeds of any collection or other realization of collateral received in connection with the exercise of remedies will be applied first to repay amounts due under the revolving credit facility, and up to an additional $150.0 million of “superpriority” obligations that we may incur in the future, before the holders of the 2019 notes receive any such proceeds.

 

 

Debt Covenants

 

The credit agreement governing the revolving credit facility and the indentures governing the notes contain a number of covenants that, among other things, restrict, subject to certain exceptions, our and our restricted subsidiaries’ ability to:

 

•

incur or guarantee additional debt or issue disqualified stock or preferred stock;

 

•

pay dividends and make other distributions on, or redeem or repurchase, capital stock;

 

•

make certain investments;

 

•

incur certain liens;

 

•

enter into transactions with affiliates;

 

•

merge or consolidate;

 

•

enter into agreements that restrict the ability of restricted subsidiaries to make dividends or other payments to the Issuer;

 

•

designate restricted subsidiaries as unrestricted subsidiaries; and

 

•

transfer or sell assets.

 

The credit agreement governing the revolving credit facility and the indentures governing the notes contain change of control provisions and certain customary affirmative covenants and events of default. As of June 30, 2014, we were in compliance with all restrictive covenants related to our long-term obligations.

 

Subject to certain exceptions, the credit agreement governing the revolving credit facility and the indentures governing the notes permit us and our restricted subsidiaries to incur additional indebtedness, including secured indebtedness.

 

Our future liquidity requirements will be significant, primarily due to debt service requirements. The actual amounts of borrowings under the revolving credit facility will fluctuate from time to time. We believe that amounts available through our revolving credit facility and incremental facilities will be sufficient to meet our operating needs for the next twelve months, including working capital requirements, capital expenditures, debt repayment obligations and potential new acquisitions.

 

As market conditions warrant, we and our major equity holders, including the Sponsor and its affiliates, may from time to time, seek to repurchase debt securities that we have issued or loans that we have borrowed, including the notes and borrowings under our revolving credit facility, in privately negotiated or open market transactions, by tender offer or otherwise.

 

Covenant Compliance

 

Under the indentures governing our notes and the credit agreement governing our revolving credit facility, our ability to engage in activities such as incurring additional indebtedness, making investments, refinancing certain indebtedness, paying dividends and entering into certain merger transactions is governed, in part, by our ability to satisfy tests based on Adjusted EBITDA.

 

“Adjusted EBITDA” is defined as net income (loss) before interest expense (net of interest income), income and franchise taxes and depreciation and amortization (including amortization of capitalized subscriber acquisition costs), further adjusted to exclude the effects of certain contract sales to third parties, non-capitalized subscriber acquisition costs, stock based compensation and certain unusual, non-cash, non-recurring and other items permitted in certain covenant calculations under the indentures governing our notes and the credit agreement governing our revolving credit facility.

 

We believe that the presentation of Adjusted EBITDA is appropriate to provide additional information to investors about the calculation of, and compliance with, certain financial covenants in the indentures governing our notes and the credit agreement governing our revolving credit facility. We caution investors that amounts presented in accordance with our definition of Adjusted EBITDA may not be comparable to similar measures disclosed by other issuers, because not all issuers and analysts calculate Adjusted EBITDA in the same manner.

  

Adjusted EBITDA is not a measurement of our financial performance under GAAP and should not be considered as an alternative to net income (loss) or any other performance measures derived in accordance with GAAP or as an alternative to cash flows from operating activities as a measure of our liquidity.

 

 

The following table sets forth a reconciliation of net loss before non-controlling interests to Adjusted EBITDA (in thousands):

 

		Three Months Ended June 30, 2014				Six Months Ended June 30, 2014				Twelve Months Ended June 30, 2014
Net loss		$	(66,271	)		$	(113,551	)		$	(185,628	)
Interest expense, net			35,140				70,228				130,633
Other income, net			(52	)			(297	)			(913	)
Income tax expense (benefit)			737				945				(9,926	)
Depreciation and amortization (1)			40,445				80,477				166,503
Amortization of capitalized creation costs			12,919				23,238				40,586
Non-capitalized subscriber acquisition costs (2)			33,855				60,731				109,173
Non-cash compensation (3)			458				903				2,129
Other adjustments (4)			11,403				23,858				51,551
Adjusted EBITDA		$	68,634			$	146,532			$	304,108

 

(1)

Excludes loan amortization costs that are included in interest expense.

(2)

Reflects subscriber acquisition costs that are expensed as incurred because they are not directly related to the acquisition of specific subscribers. Certain other industry participants purchase subscribers through subscriber contract purchases, and as a result, may capitalize the full cost to purchase these subscriber contracts, as compared to our organic generation of new subscribers, which requires us to expense a portion of our subscriber acquisition costs under GAAP.

(3)

Reflects non-cash compensation costs related to employee and director stock and stock option plans.

(4)

Other adjustments represent primarily the following items (in thousands):

 

		Three Months Ended June 30, 2014				Six Months Ended June 30, 2014				Twelve Months Ended June 30, 2014
Product development (a)		$	3,150			$	6,988			$	14,460
Purchase accounting deferred revenue fair value adjustment (b)			1,352				2,757				5,783
Subcontracted monitoring agreement (c)			1,100				2,225				3,303
Non-operating legal and professional fees			1,085				1,119				2,908
Fire related losses, net of probable insurance recoveries (d)			1,001				2,659				2,659
Information technology implementation (e)			824				2,134				3,364
Monitoring fee (f)			770				1,445				2,795
Start-up of new strategic initiatives (g)			465				832				3,493
CMS technology impairment loss (h)			-				1,351				1,351
Non-cash contingent liabilities			-				-				6,500
All other adjustments			1,656				2,348				4,935
Total other adjustments		$	11,403			$	23,858			$	51,551

 

(a)

Costs related to the development of future products and services, including associated software.

(b)

Add back revenue reduction directly related to purchase accounting deferred revenue adjustments.

(c)

Run-rate savings from committed future reductions in subcontract monitoring fees.

(d)

Fire relates losses, net of insurance recoveries of $3.0 million considered probable at June 30, 2014. (See Note 10 to the accompanying unaudited condensed consolidated financial statements).

(e)

Costs related to the implementation of new information technologies.

(f)

Blackstone Management Partners L.L.C monitoring fee (See Note 14 to the accompanying unaudited condensed consolidated financial statements).

(g)

Costs related to the start-up of potential new service offerings and sales channels.

(h)

CMS technology impairment loss (See Note 8 to the accompanying unaudited condensed consolidated financial statements).

 

  

Other Factors Affecting Liquidity and Capital Resources

 

Vehicle Leases. Since 2010, we have leased, and expect to continue leasing, vehicles primarily for use by our field service technicians. For the most part, these leases have 36 month durations and we account for them as capital leases. At the end of the lease term for each vehicle we have the option to either (i) purchase it for the estimated end-of-lease fair market value established at the beginning of the lease term; or (ii) return the vehicle to the lessor to be sold by them and in the event the sale price is less than the estimated end-of-lease fair market value we are responsible for such deficiency. As of June 30, 2014, our total capital lease obligations were $12.2 million, of which $4.3 million is due within the next 12 months.

 

Aircraft Lease. In December 2012, we entered into an aircraft lease agreement for the use of a corporate aircraft, which is accounted for as an operating lease. Upon execution of the lease, we paid a $5.9 million security deposit which is refundable at the end of the lease term. Beginning January 2013, we are required to make 156 monthly rental payments of approximately $83,000 each. We also have the option to extend the lease for an additional 36 months upon expiration of the initial term. The lease agreement also provides us the option to purchase the aircraft on certain specified dates for a stated dollar amount, which represents the current estimated fair value as of the purchase date.

 

Off-Balance Sheet Arrangements

 

Currently we do not engage in off-balance sheet financing arrangements.

 

Critical Accounting Estimates

 

In preparing our unaudited Condensed Consolidated Financial Statements, we make assumptions, judgments and estimates that can have a significant impact on our revenue, income (loss) from operations and net loss, as well as on the value of certain assets and liabilities on our unaudited Condensed Consolidated Balance Sheets. We base our assumptions, judgments and estimates on historical experience and various other factors that we believe to be reasonable under the circumstances. Actual results could differ materially from these estimates under different assumptions or conditions. At least quarterly, we evaluate our assumptions, judgments and estimates and make changes accordingly. Historically, our assumptions, judgments and estimates relative to our critical accounting estimates have not differed materially from actual results. We believe that the assumptions, judgments and estimates involved in the accounting for income taxes, allowance for doubtful accounts, valuation of intangible assets, and fair value have the greatest potential impact on our unaudited Condensed Consolidated Financial Statements; therefore, we consider these to be our critical accounting estimates. For information on our significant accounting policies, see Note 1 to our unaudited Condensed Consolidated Financial Statements.

 

Revenue Recognition

 

We recognize revenue principally on three types of transactions: (i) monitoring, which includes RMR, (ii) service and other sales, which includes non-recurring service fees charged to our subscribers provided on contracts, contract fulfillment revenues and sales of products that are not part of our service offerings, and (iii) activation fees on the subscriber contracts, which are amortized over the estimated life of the subscriber relationship.

 

Monitoring services for our subscriber contracts are billed in advance, generally monthly, pursuant to the terms of subscriber contracts and recognized ratably over the service period. RMR is recognized monthly as services are provided in accordance with the rates set forth in our subscriber contracts. Costs of providing ongoing monitoring services are expensed in the period incurred.

 

Any services included in service and other sales revenue are recognized upon provision of the applicable services. Revenue from 2GIG product sales was recognized when title passed to the customer, which was generally upon shipment from the warehouse of our third-party logistics provider. Revenue generated by Vivint from the sale of products that are not part of the service offerings is recognized upon installation. Contract fulfillment revenue represents fees received from subscribers at the time of, or subsequent to, the in-term termination of their contract. This revenue is recognized when payment is received from the subscriber.

  

Activation fees are typically charged upon the generation of a new subscriber. This revenue is deferred and recognized over a pattern that reflects the estimated life of a subscriber relationship.

 

Revenue from the sale of subscriber contracts to third parties is recognized when ownership of the contracts has transferred to the purchaser. Any unamortized deferred revenue and costs related to contract sales are recognized at that time of the sale.

 

  

Subscriber Acquisition Costs

 

A portion of the direct costs of acquiring new subscribers, primarily sales commissions, equipment, and installation costs, are deferred and recognized over a pattern that reflects the estimated life of the subscriber relationships. We amortize these costs using a 150% declining balance method over 12 years and convert to a straight-line methodology when the resulting amortization charge is greater than that from the accelerated method for the remaining estimated life. We evaluate attrition on a periodic basis, utilizing observed attrition rates for our subscriber contracts and industry information and, when necessary, make adjustments to the estimated life of the subscriber relationship and amortization method.

 

Subscriber acquisition costs represent the costs related to the origination of new subscribers. A portion of subscriber acquisition costs is expensed as incurred, which includes costs associated with the direct-to-home sale housing, marketing and recruiting, certain portions of sales commissions (residuals), overhead and other costs, considered not directly and specifically tied to the origination of a particular subscriber. The remaining portion of the costs is considered to be directly tied to subscriber acquisition and consist primarily of certain portions of sales commissions, equipment, and installation costs. These costs are deferred and recognized in a pattern that reflects the estimated life of the subscriber relationships. Subscriber acquisition costs are largely correlated to the number of new subscribers originated.

 

Accounts Receivable

 

Accounts receivables consist primarily of amounts due from subscribers for RMR services. Accounts receivable are recorded at invoiced amounts and are non-interest bearing. The gross amount of accounts receivable has been reduced by an allowance for doubtful accounts of approximately $4.5 million and $1.9 million at June 30, 2014 and December 31, 2013, respectively. We estimate this allowance based on historical collection rates, attrition rates, and contractual obligations underlying the sale of the subscriber contracts to third parties. As of June 30, 2014 and December 31, 2013, no accounts receivable were classified as held for sale. Provision for doubtful accounts recognized and included in general and administrative expenses in the accompanying unaudited condensed consolidated statements of operations totaled $4.8 million and $3.0 million for the three months ended June 30, 2014 and 2013, respectively, and $7.3 million and $5.4 million for the six months ended June 30, 2014 and 2013, respectively.

 

Loss Contingencies

 

We record accruals for various contingencies including legal proceedings and other claims that arise in the normal course of business. The accruals are based on judgment, the probability of losses and, where applicable, the consideration of opinions of legal counsel. We record an accrual when a loss is deemed probable to occur and is reasonably estimable. Factors that we consider in the determination of the likelihood of a loss and the estimate of the range of that loss in respect of legal matters include the merits of a particular matter, the nature of the litigation, the length of time the matter has been pending, the procedural posture of the matter, whether we intend to defend the matter, the likelihood of settling for an insignificant amount and the likelihood of the plaintiff accepting an amount in this range. However, the outcome of such legal matters is inherently unpredictable and subject to significant uncertainties.

 

Goodwill and Intangible Assets

 

Purchase accounting requires that all assets and liabilities acquired in a transaction be recorded at fair value on the acquisition date, including identifiable intangible assets separate from goodwill. For significant acquisitions, we obtain independent appraisals and valuations of the intangible (and certain tangible) assets acquired and certain assumed obligations as well as equity. Identifiable intangible assets include customer relationships, trade names and trademarks and developed technology, which equaled $772.7 million at June 30, 2014. Goodwill represents the excess of cost over the fair value of net assets acquired and was $836.7 million at June 30, 2014.

 

The estimated fair values and useful lives of identified intangible assets are based on many factors, including estimates and assumptions of future operating performance and cash flows of the acquired business, estimates of cost avoidance, the nature of the business acquired, the specific characteristics of the identified intangible assets and our historical experience and that of the acquired business. The estimates and assumptions used to determine the fair values and useful lives of identified intangible assets could change due to numerous factors, including product demand, market conditions, regulations affecting the business model of our operations, technological developments, economic conditions and competition. The carrying values and useful lives for amortization of identified intangible assets are reviewed annually during our fourth fiscal quarter and as necessary if changes in facts and circumstances indicate that the carrying value may not be recoverable and any resulting changes in estimates could have a material adverse effect on our financial results.

  

When we determine that the carrying value of intangible assets, goodwill and long-lived assets may not be recoverable, an impairment charge is recorded. Impairment is generally measured based on valuation techniques considered most appropriate under the circumstances, including a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model or prevailing market rates of investment securities, if available.

 

  

We conduct a goodwill impairment analysis annually in our fourth fiscal quarter, and as necessary if changes in facts and circumstances indicate that the fair value of our reporting units may be less than their carrying amount. Under applicable accounting guidance, we are permitted to use a qualitative approach to evaluating goodwill impairment when no indicators of impairment exist and if certain accounting criteria are met. To the extent that indicators exist or the criteria are not met, we use a quantitative approach to evaluate goodwill impairment. Such quantitative impairment assessment is performed using a two-step, fair value based test. The first step requires that we compare the estimated fair value of our reporting units to the carrying value of the reporting unit’s net assets, including goodwill. If the fair value of the reporting unit is greater than the carrying value of its net assets, goodwill is not considered to be impaired and no further testing is required. If the fair value of the reporting unit is less than the carrying value of its net assets, we would be required to complete the second step of the test by analyzing the fair value of its goodwill. If the carrying value of the goodwill exceeds its fair value, an impairment charge is recorded.

 

Property and Equipment

 

Property and equipment are stated at cost and depreciated on the straight-line method over the estimated useful lives of the assets or the lease term, whichever is shorter. Amortization expense associated with leased assets is included with depreciation expense. Routine repairs and maintenance are charged to expense as incurred. We periodically assess potential impairment of our property and equipment and perform an impairment review whenever events or changes in circumstances indicate that the carrying value may not be recoverable.

 

Income Taxes

 

We account for income taxes based on the asset and liability method. Under the asset and liability method, deferred tax assets and deferred tax liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis and operating loss and tax credit carryforwards. Valuation allowances are established when necessary to reduce deferred tax assets when it is determined that it is more likely than not that some portion of the deferred tax asset will not be realized.

 

We recognize the effect of an uncertain income tax position on the income tax return at the largest amount that is more-likely-than-not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained. Our policy for recording interest and penalties is to record such items as a component of the provision for income taxes.

 

Recent Accounting Pronouncements

 

In May 2014, the FASB issued authoritative guidance which clarifies the principles used to recognize revenue for all entities. The new guidance requires companies to recognize revenue when it transfers goods or services to a customer in an amount that reflects the consideration to which a company expects to be entitled. The guidance is effective for annual and interim periods beginning after December 15, 2016. The guidance allows for either a "full retrospective" adoption or a "modified retrospective" adoption, however early adoption is not permitted. We are currently evaluating the impact the adoption of this guidance will have on our consolidated financial statements.

 

In February 2013, the FASB issued authoritative guidance which expands the disclosure requirements for amounts reclassified out of accumulated other comprehensive income (“AOCI”). The guidance requires an entity to provide information about the amounts reclassified out of AOCI by component and present, either on the face of the income statement or in the notes to financial statements, significant amounts reclassified out of AOCI by the respective line items of net income but only if the amount reclassified is required under GAAP to be reclassified to net income in its entirety in the same reporting period. For other amounts, an entity is required to cross-reference to other disclosures required under GAAP that provide additional detail about those amounts. This guidance does not change the current requirements for reporting net income or OCI in financial statements. The guidance became effective for us in the first quarter of fiscal year 2014. The adoption of this guidance did not have a material impact on our financial position, results of operations or cash flows.

 

In July 2013, the FASB issued authoritative guidance which amends the guidance related to the presentation of unrecognized tax benefits and allows for the reduction of a deferred tax asset for a net operating loss carryforward whenever the net operating loss carryforward or tax credit carryforward would be available to reduce the additional taxable income or tax due if the tax position is disallowed. This guidance became effective for us for annual and interim periods beginning in fiscal year 2014. The adoption of this guidance did not have a material impact on our financial position, results of operations or cash flows.

 

  

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Our operations include activities in the United States, Canada and New Zealand. These operations expose us to a variety of market risks, including the effects of changes in interest rates and foreign currency exchange rates. We monitor and manage these financial exposures as an integral part of our overall risk management program.

 

Interest Rate Risk

 

On November 16, 2012, we entered into a revolving credit facility that bears interest at a floating rate. As a result, we may be exposed to fluctuations in interest rates to the extent of our borrowings under the revolving credit facility. Our long-term debt portfolio is expected to primarily consist of fixed rate instruments. To help manage borrowing costs, we may from time to time enter into interest rate swap transactions with financial institutions acting as principal counterparties. Assuming the borrowing of all amounts available under our revolving credit facility, if interest rates related to our revolving credit facility increase by 1% due to normal market conditions, our interest expense will increase by approximately $2.0 million per annum.

 

We had no borrowings under the revolving credit facility as of June 30, 2014.

 

Foreign Currency Risk

 

We have exposure to the effects of foreign currency exchange rate fluctuations on the results of our Canadian operations. Our Canadian operations use the Canadian dollar to conduct business but our results are reported in U.S. dollars. Our operations in New Zealand are immaterial to our overall operating results. We are exposed periodically to the foreign currency rate fluctuations that affect transactions not denominated in the functional currency of our U.S. and Canadian operations. We do not use derivative financial instruments to hedge investments in foreign subsidiaries since such investments are long-term in nature.

 

ITEM  4. CONTROLS AND PROCEDURES

 

Disclosure Controls and Procedures

 

We maintain disclosure controls and procedures (as that term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) that are designed to ensure that information required to be disclosed in our reports under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosures. Any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. Our management, with the participation of our principal executive officer and principal financial officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2014, the end of the period covered by this report. Based upon that evaluation, our principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, the design and operation of our disclosure controls and procedures were effective to accomplish their objectives at the reasonable assurance level.

 

Internal Control Over Financial Reporting

 

Internal Control Procedures

 

During the year ended December 31, 2013, we implemented a company employee service portal. Functionality within this portal calculates certain expense items related to employee payroll. Additionally, during the six months ended June 30, 2014, we implemented Customer Service, Customer Billing and Inventory systems. During the remainder of the year we will continue to enhance these systems and continue to improve and enhance supporting internal controls. We believe the systems, as implemented, and our current system of internal control over financial reporting continue to provide reasonable assurance our financial reporting is accurate and our established policies are followed.

 

Because of its inherent limitations, internal control over financial reporting, including disclosure controls, may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

  

Changes in Internal Control Over Financial Reporting

 

Except as described above, there have been no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter ended June 30, 2014 that have materially affected, or that are reasonably likely to materially affect, our internal control over financial reporting.

 

 

Part II. OTHER INFORMATION

 

ITEM  1. LEGAL PROCEEDINGS

 

We are engaged in the defense of certain claims and lawsuits arising out of the ordinary course and conduct of our business and have certain unresolved claims pending, the outcomes of which are not determinable at this time. Our subscriber contracts include exculpatory provisions as described under “—Subscriber Contracts—Other Terms” in our Annual Report on Form 10-K. We also have insurance policies covering certain potential losses where such coverage is available and cost effective. In our opinion, any liability that might be incurred by us upon the resolution of any claims or lawsuits will not, in the aggregate, have a material adverse effect on our financial condition or results of operations. See Note 13 of our unaudited Condensed Consolidated Financial Statements included elsewhere in this Quarterly Report on Form 10-Q for additional information.

 

ITEM  1A. RISK FACTORS

 

For a discussion of the Company’s potential risks or uncertainties, please see “Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013 (the “Annual Report”). There have been no material changes to the risk factors disclosed in the Annual Report.

 

ITEM  2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

 

None.

 

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

 

None.

 

ITEM  4. MINE SAFETY DISCLOSURES

 

Not applicable.

 

  

ITEM 5. OTHER INFORMATION

 

Pursuant to Section 219 of the Iran Threat Reduction and Syria Human Rights Act of 2012, which added Section 13(r) of the Exchange Act, the Company hereby incorporates by reference herein Exhibit 99.2 of this report, which includes disclosures publicly filed and/or provided to the Blackstone Group L.P., an affiliate of our major shareholders, by Travelport Limited which may be considered the Company’s affiliate.

 

ITEM 6. EXHIBITS

 

Exhibits

 

Incorporated by Reference

Exhibit Number

Exhibit Title

Form

File No.

Exhibit No.

Filing Date

Provided Herewith

10.1

Employment Agreement, dated as of August 7, 2014, between APX Group, Inc. and Alex Dunn

X

10.2

Employment Agreement, dated as of August 7, 2014, between APX Group, Inc. and Todd Pedersen

X

31.1

Certification of the Registrant’s Chief Executive Officer, Todd Pedersen, pursuant to Rule 13a-14 of the Securities Exchange Act of 1934

X

31.2

Certification of the Registrant’s Principal Financial Officer, Mark Davies, pursuant to Rule 13a-14 of the Securities Exchange Act of 1934

X

32.1

Certification of the Registrant’s Chief Executive Officer, Todd Pedersen, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

X

32.2

Certification of the Registrant’s Principal Financial Officer, Mark Davies, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

X

99.1

Stock Purchase Agreement, dated as of February 13, 2013, by and among Nortek, Inc. and APX Group, Inc.

8-K of Nortek Inc.

001-34697

2.1

4/1/13

99.2

Section 13(r) Disclosure

X

101.INS

XBRL Instance Document.

X

101.SCH

XBRL Taxonomy Extension Schema Document.

X

101.CAL

XBRL Taxonomy Extension Calculation Linkbase Document.

X

101.DEF

XBRL Taxonomy Extension Schema Document.

X

101.LAB

XBRL Taxonomy Extension Label Linkbase Document.

X

101.PRE

XBRL Taxonomy Extension Presentation Linkbase Document.

X

 

  

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.

 

	APX Group Holdings Inc.
Date: August 8, 2014	By:	/S/ TODD PEDERSEN
		Todd Pedersen
		Chief Executive Officer and Director (Principal Executive Officer)
Date: August 8, 2014	By:	/S/ MARK DAVIES
		Mark Davies
		Chief Financial Officer (Principal Financial Officer)